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:
- 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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