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 and partnerships operating an active trade or business.
Payroll Tax Savings
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) only on the $40,000 of wages, which means the payroll taxes 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.
Note: The payroll tax savings angle applies to partners and partnerships, too--and also as a practical matter to many small C corporations.
Double-deducting Fringe Benefits
Here's something else weird about operating as an S corporation.
On an S corporation tax return, some fringe benefit and pension expense deductions save not just income taxes but also either self-employment taxes or Social Security and Medicare taxes. In effect then, as as compared to a sole proprietorship or partnership, the business owner gets to use the tax deduction twice--one for income taxes and once for payroll taxes.
Consult your tax advisor if you have questions, but know that self-employed health insurance premiums, health savings accounts (HSA) contributions, and SEP-IRA contributions all save both income taxes and self-employment (or Social Security and Medicare taxes) when they appear on an S corporation tax return.
In comparison, these deductions typically save only income taxes when they appear on a business owner's sole proprietorship Schedule C form (which goes inside the individual's 1040 tax return.)
The tax savings that come from this double-deductibility might easily add up to several thousand dollars a year: $2,000? $4,000? More?
Avoiding the Obamacare Surtaxes
Another tax benefit of operating as an S corporation (as compared to a sole proprietorship) relates to the Affordable Care Act (also known as Obamacare).An active shareholder-employee in an S corporation won't pay the Obamacare surtax (also known as the net investment income tax) on S corporation profit.
In comparison, he or she will in effect pay this tax on sole proprietorship or partnership profits. (This savings might often amount to several hundred dollars or more of annual savings per shareholder.)
Bumping Up the Domestic Production Activities Deduction
A final S corporation tax benefit worth mentioning: Because an S corporation pushes up the wages expense reported on a business tax return, reforming a sole proprietorship or a small partnership as an S corporation may also bump up the domestic production activities deduction that small manufacturers get to take.
The domestic production activities deduction (DPAD) lets manufacturers (including small construction companies) take a "fake" deduction equal to 9% of their income, but the deduction can't exceed 50% of the business's wages. For some small sole proprietorships and partnerships that rely on their owner or owners for labor, that wages limit does reduce the DPAD deduction.
Estimating the value of this deduction is problematic, but for a profitable one-worker construction firm, the DPAD deduction might be worth several thousand dollars a year.
Want to Download a Do-it-yourself S Corporation Kit?
Note, too, that if you want to get a better idea about how to form an S corporation in your state, you can download one of our affordable, do-it-yourself kits.
We publish and sell affordable kits for all fifty states. As with all of our digital publications, we provide a money back guarantee: If you don't get what you want, just request a refund. To get to the page that lets you download the kits for the state you want, click the state name in the list of states along the left edge of the web page.
Additional Articles from the FAQ
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:
- What are the tax advantages of an S corporation?
- Does incorporating a business create a tax shelter?
- What tax-free fringe benefits can an S corporation offer?
- How low can you really set shareholder-employee salaries in an S corporation?
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
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