How much tax can an S corporation really save?

If you're operating a business as an S corporation--let's be clear about this--the big tax savings come from minimizing the self-employment taxes you pay as a business owner. This reality means that the whole trick to maximizing the tax benefit of an S corporation rests on setting a low yet reasonable shareholder salary for yourself--and then taking large shareholder distributions.

People are often confused, however, about just how much tax an S corporation can actually save. Therefore, to make sure you understand the tax savings, let us give you two quick examples showing the way that S corporation economics work. We'll then follow those examples with some additional information to help you understand even better how much money an S corporation really saves.

Example #1 - $100,000-a-year Contractor

Suppose you're in a personal service business, working as a contractor or consultant, and that you make $100,000 a year.

If you operate your business as a sole proprietorship or as a limited liability company taxed as a sole proprietorship, you'll typically pay around $15,000 in self-employment taxes.

Using an S corporation, however, might allow you to split this profit into $50,000 of wages and $50,000 of distribution. And if you can do this, the S corporation saves you about $7,500 annually. The savings come because you don't have to pay the 15.3% self-employment tax on the $50,000 of distribution.

Note: I'm being rough in my calculations here. One complication I've ignored, for example, is how a part of your self-employment tax becomes a deduction for self-employment tax calculations.

Example #2 - $800,000-a-year Entrepreneur

Suppose you are a super-successful, married entrepreneur annually making, say, $800,000.

If you operate your business as a sole proprietorship, you will annually pay about $43,000 in combined self-employment taxes: A 15.3% Social Security and Medicare tax on roughly the first $118,500 of your income, a 2.9% Medicare tax on the amount between $118,500 and $250,000, and then a 3.8% Medicare tax on the income over $250,000.

If you re-form your business as an S corporation, set your annual salary to $100,000 and pay out the remaining $700,000 as a distribution, the S corporation option saves you approximately $28,000 each year in employment taxes. The savings come because you don't have to pay any Social Security taxes or Medicare taxes or Affordable Care Act taxes (aka Obamacare taxes) on the $700,000 distribution.

Note: The new 3.8% Affordable Care Act (Obamacare) tax applies to earnings and investment income after an individual's income rises above $200,000 and after a married couple's income rises above $250,000. S corporation earnings aren't subject to this 3.8% surtax if the shareholder is active in the business, however.

Clearly, an S corporation can save business owners lots of tax.

Important Point #1: Savings Annual

Let me also underline two points easy to miss in the preceding paragraphs. First, these savings amounts are annual. In other words, an S corporation shareholder-employee might save these very substantial amounts each and every year.

Note: Annually saving $7,500 over decades of self-employment quite literally grows to a million dollars of investment wealth. And annually saving $25,000 over decades of self-employment quite possibly grows to several million dollars of investment wealth.

Important Point #2: Savings Per-shareholder

Another important point prospective S corporation shareholders don't want to miss: The annual savings I talk about here are "per-shareholder" savings. In a situation where two or three partners operate the business as a S corporation, each "partner" (or, more accurately, each shareholder-employee) would enjoy these annual savings amounts.

In short, an S corporation can usually produce true, substantial savings for each shareholder-employee for each year an S corporation operates... as long as the shareholder-employee or shareholder-employees can set reasonably low shareholder compensation.

Tip: Another question-and-answer discussion provided by this FAQ discusses the issue of reasonable shareholder-employee compensation.