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Saving Business Taxes with an S Corporation: A Short Primer

S corporations, or Subchapter S corporations, produce several tax benefits as compared to sole proprietorships, partnerships, and C corporations.

The big benefit--and the one that people usually talk about--is the payroll tax savings. To understand how this works, let's compare two alternatives: A sole proprietor making $90,000 a year and an S corporation making $90,000 a year.

Of course, the taxes that a sole proprietor pays depend on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes.

In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social Security and Medicare tax) equals $13,000.

Things usually work differently when a business has made the Subchapter S election, however. To make calculations easy, assume it is owned by a single shareholder. The corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000.

In this case, even though the two businesses make the exact same amount of money, the sole proprietor pays roughly $7,000 more in tax each year.

In addition to the big benefit of self-employment tax reduction, S corporations also provide two other useful benefits--benefits which are a little more difficult to quantify but still important nonetheless.

One such benefit is that an S corporation can use losses (such as those that often occur in the early startup years) as tax deductions on the shareholders personal income tax returns.

Additionally, the S corporation is not taxed on its profits--at least by the federal government.

If you would like to explore the tax benefits of Subchapter S status in more detail, one or more of the following articles might interest you:

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