How much tax can an S corporation really save its shareholders-employees?

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. This reality means that the whole trick to maximizing the tax benefit of an S corporation rests on setting a low yet reasonable salary—and then taking large shareholder distributions.

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

Example #1: Suppose you're in a personal service business and 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 pay around $15,000 in self-employment taxes. Using an S corporation, however, allows you to split this profit into $50,000 of wages and $50,000 of distribution. And if you 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.

Example #2: Suppose you are a super-successful entrepreneur annually making, say, $800,000. If you operate your business as a sole proprietorship, you will annually pay about $35,000 in combined self-employment taxes: A 15.3% "Social Security and Medicare" tax on roughly the first $100,000 of your income and then a 2.9% "Medicare" tax on the amount above $100,000. If you reform 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 $20,000 each year in employment taxes. The savings come because you don't have to pay the 2.9% "Medicare" tax on the $700,000 distribution.

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

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 $20,000 over decades of self-employment quite possibly grows to several million dollars of investment wealth.

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.

Unfortunately, I also have some bad news to share about S corporation tax savings. Starting in 2011, the attractiveness of the S corporation option for some professional service businesses greatly lessens. In mid-2010, congress as part of the "American Jobs and Closing Tax Loopholes Act of 2010" said that some professional service S corporations are disqualified from playing the sort of accounting tricks described in the preceding paragraphs. Accordingly, if you're a one-person S corporation practicing any of the common professions (law medicine, accounting, engineering, dentistry, consulting and so forth), you need to proceed cautiously before incorporating. Note that I've written another eBook, Dodging Disqualification that provides a thorough discussion of the new disqualified rules and the relevant tax planning issues.

Tip: Another question-and-answer discussion provided by this FAQ discusses the issue of reasonable shareholder-employee compensation. You may also be interested in acquiring the e-document we sell at this web site: Setting Low Salaries for S Corporation shareholder employers. (The e-document provides an extensive discussion of the issue and many, very concrete tax planning tips.)

Back to list of frequently asked questions