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.
If you're considering using an S corporation for your business, therefore, you want to understand these benefits to make the best decision about whether or not to go the "S corporation route" and so you can maxmize your tax savings.
Payroll Tax Savings: Maybe $5,000 to $10,000 Annually?
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 $100,000 a year and an S corporation making $100,000 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 most of the $100,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social Security and Medicare tax) equals $13,000.
Things work differently when a business has made the Subchapter S election, however.
To make calculations easy, assume it is owned by a single shareholder.
In this case, the corporation must break the $100,000 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 $60,000, the business and the employee pay 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.
But that other $60,000? Even though the owner also gets that profit, neither the business nor the owner pays self-employment taxes or payroll taxes.
This means, then, that even though the two businesses make the exact same amount of money, the sole proprietor pays roughly $7,000 more in tax each year if he or she would if the business operated as an S corporation.
Two quick notes: First, the payroll tax savings angle applies to partners and partnerships, too--and also as a practical matter to many small C corporations.
Second, just so you know, I've been a bit rough in my calculations. The self-employment tax savings will amount to roughly $7,000 in a case like I describe. But the actual tax calculations work a bit more complicated. (You get to deduct half of the self-employment taxes from the amount subject to self-employment tax, for example. And also from the amount subject to income taxes.)
Double-deducting Fringe Benefits: $2,000 to $4,000 Annually?
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, and 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: $1,000 or More Annually?
Another tax benefit of operating as an S corporation relates to the Affordable Care Act (also known as Obamacare).
An active shareholder-employee in an S corporation won't pay the 3.8% Obamacare surtax (also known as the net investment income tax) on S corporation profit.
In comparison, he or she will pay the Obamacare tax on sole proprietorship or partnership profits.
This savings might often amount to a thousand dollars or more of annual savings per shareholder even for small S corporations.
For larger, very successful S corporations, the Obamacare tax savings can run tens or even hundreds of thousands of dollars a year.
An example: If you run a successful business and avoid paying the 3.8% Obamacare tax on $500,000 of business income, you save roughly $19,000 a year. If things really ramp up and you make $5,000,000 a year, you save $190,000 a year.
Sec. 199 Domestic Production Activities Deduction: $2000 to $3000 Annually?
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 Sec. 199 Domestic Production Activities Deduction (aka "DPAD") that small manufacturers get to take.
The Sec. 199 DPAD loophole 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 reduces or eliminates the DPAD deduction.
Consider the case of a successful one person construction company operated as a sole proprietorship. Assume the proprietor earns $200,000 a year but has no employees because he runs a team of independent contractors and incorporated vendors.
In this situation, the business owner doesn't get a Sec. 199 Domestic Production Activities Deduction. Technically, he would be eligible. But because the owner has zero wages, the deduction is limited to 50% of zero, which equals zero.
Say the owner instead runs the business as an S corporation, perhaps paying the owner $100,000 in wages. That means the business has $100,000 of leftover profit. And that means the 9% Sec. 199 DPAD deduction adds an extra $9,000 tax deduction on the owner's tax return. That $9,000 tax deduction might easily save the owner $2,000 to $3,000 annually in taxes.
Downloadable Do-it-yourself S Corporation Kit?
By the way, 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 there 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 upper 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.
Often the best tax saving tool private companies have? The Section 199A deduction which allows them to avoid taxes on the last 20 percent of their income.Read More
Using an S corporation for your business? To maximize savings, you need to minimize the salary paid to shareholders. But this decision is tricky.Read More
Nearly secret, the federal government's employee retention credits provide tremendous payroll tax savings for most small businesses... A new book from our firm explains.Info here