Can Becoming an S Corporation Reduce Taxes? Yes, Here’s How…
A Brief Background on Self-Employment Tax
Sole proprietorships (Schedule C filers) pay self-employment (SE) tax of 15.3% on their net earnings from self-employment. Net earnings from self-employment is basically equal to your business profit for the year multiplied by 92.35% (this is done to effectively allow a deduction for the employer portion of self-employment tax).
Example: You have $50,000 profit in your business for the year. To determine net self-employment income, you multiply your $50,000 profit by 92.35% which equals $46,175. This $46,175 is then multiplied by the 15.3% self-employment tax rate to calculate your SE tax for the year of $7,064.78.
The reason you multiply your profit by 92.35% is to allow a deduction from your profit for the 7.65% (100% minus 92.35%) employer portion of self-employment tax.
How does an S Corp Reduce SE Tax?
S Corporation owners pay FICA taxes (i.e., self-employment taxes) on wages they draw from the corporation. S corporation owners do not pay FICA taxes on profit or on distributions they take from the corporation, assuming the owners are drawing reasonable compensation from the S corporation.
Example: Joan owns 100% of S Corp, Inc. S Corp, Inc. has $55,000 in profit (after paying owner wages of $45,000) for the year. Assume Joan’s wages of $45,000 for the year are reasonable. Joan pays FICA taxes (employer and employee portions) of $6,885 on her $45,000 wages ($45,000 * 15.3%). She does not pay FICA taxes on the $55,000 of profit she had during the year.
Had Joan operated her business as a proprietorship, her FICA tax liability is calculated as follows:
Business Profit: $100,000
Net Earnings from SE: 92,350
Times: SE Tax Rate: 15.3%
SE Tax= $14,129
As you can see, Joan saves $7,244 ($14,129 minus $6,885) in FICA taxes by being an S corporation.
Note: If the S corporation pays unreasonably low wages, the IRS can recharacterize any distributions as wages and subject the owner to additional FICA taxes, plus penalties and interest.
How to Establish Reasonable Wages
Determining reasonable wages is based on a variety of factors, so it is a subjective determination. Factors that are relevant include:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation
There is a limit on the amount of proprietorship profit/wages that are subject to SE tax. Wages/proprietorship profit under $106,800 are subject to SE tax of 15.3% (including Social Security and Medicare portions). Wages/proprietorship profit over $106,800 are subject to SE tax of 2.45% (Medicare portion only).
Starting in 2013, an additional 0.9% tax is imposed on wages/proprietorship profit in excess of $200,000 for single filers and $250,000 for joint filers.
What are the SE tax rules for LLCs? That’s a whole different bowl of mostaccioli. Stay tuned for the answer.
Buzzkill Disclaimer: Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.