In this video I’m going to go over how exactly you save tax by using an S-Corp. Very often I’ll see people start S-Corps when they’re not saving any tax, so all they do is create extra administrative work with no benefit. There are also situations where an S-Corp may be a terrible choice for you. So let’s go over why S-corps can save you tax, and then we’ll also cover the areas of exposure and downsides that you should consider before making the election.
Ok so why do people become S-Corps and how do they save tax? The simple answer is that S-Corps do not reduce your income tax, so when you think of looking up those income tax brackets online, those stay the same. The tax savings is solely self-employment tax, which is social security and medicare.
Social security is 12.4% of up to the first $147,000 of your income when you’re self employed and that threshold increases every year. Medicare is 2.9% of all earned income and if you’re a high income earner, which is $250,000 for a married filing joint filer and $200,000 for most others, then you get to pay an additional 0.9% to medicare to get to 3.8% rate.
So, why do people do S-Corps? Well it’s because you can minimize self-employment tax, and we just went over the social security and medicare rates, which are really really high because that’s in addition to income tax. That’s why most business owners get blown away by their tax bill when they first go into business, because they’re thinking ok my tax bracket is 20%, well that’s in addition to this 15.3% social security and medicare tax, and then none of that was already withheld. So you hopefully saved 35% of your income in the bank or you will be setting up an IRS installment agreement with interest and penalties.
So let’s go over how the S-Corp savings work with an example. The main requirement is that you have to set a reasonable compensation for yourself to pay through payroll on a w-2 from your own S-Corp. The reason is that the income not on a w-2 from your S-Corp is not subject to self-employment tax. So if you don’t pay yourself anything through a w-2, then you will have paid no social security or medicare tax, which would be amazing, which is why it’s not allowed. So you must set a reasonable compensation and that is the only income from your S-Corp business that will be subject to social security and medicare tax.
This is how the savings works. You take the reasonable compensation you set, which I’ll be doing a separate video in more detail, but it is essentially what it sounds like – you need to set a wage that is representative of pay for the work you are doing for your business. This is a subjective standard but you want to be keeping your support and that will be the focus of another video. Let’s say you set a $100,000 salary for yourself. You would then save 15.3% on the difference between your $100,000 salary and the $147,000 threshold where social security tax drops off, so 15.3% times $47,000 is $7,191. That’s the main savings. Then you are also saving medicare tax on the amount over the threshold, so if you netted 200k, the additional savings is the 2.9% on the 53k over the $147,000 threshold, which is $1,537.
Who Does Not Save Tax as an S-Corp?
So let’s go over who doesn’t save much or any tax at all from an S-Corp.
First, you won’t be saving anything at all if your reasonable compensation number is greater than or equal to the net taxable income of your business. This is very applicable to start ups. Even if it may make sense for you to be an S-Corp once your business grows, that doesn’t mean you have to start as one. If your business is netting $20,000 and you’re working full time, you aren’t going to save tax because you’re likely not going to be able to justify a salary lower than $20,000. Instead you could start as a LLC with the default classification and then transition to an S-Corp when it makes sense.
Second, your savings are going to be limited if you cannot justify a low salary based on your education and skillset. So if you’re a doctor or engineer and someone with your skillset is close to that $147,000 threshold, then you’re already capped on social security tax. So the medicare tax rate is only going to realize substantial savings if your net taxable income is significantly more than your reasonable comp. So if your business netted $200,000, but $150,000 of that would be your salary, then the savings is only 50k times 2.9%, which is $1,450. You may say ok well that’s still totally worth it, but you have to remember that you are adding administrative costs with an S-Corp, and you have to file an additional business tax return plus quarterly payroll returns, and you’re almost certainly spending that amount or more on those filings.
When Should You Not Create an S-Corp?
Now let’s go over some of the situations where you may not want to create an S-Corp and also go over some exposure areas of an S-Corp because even if you are going to save tax, you still won’t want to do it in certain situations.
- Double Tax – If you generate double tax, which I have an entire video on linked above, but you want to be really careful if you’re a business that will have third party debt, like financing for equipment or real property. You never want to generate S-Corp double tax, it’s always a bad tax result.
- Ineligible Shareholders – There are certain individuals or businesses that cannot own an S-Corp, which includes LLC partnerships, non-grantor trusts, nonresident aliens, and there are more. So make sure you’re an eligible shareholder.
- Several Owners – While this one is manageable, it usually doesn’t make sense because you cannot have disproportionate contributions and distributions on an S-Corp because that’s considered to be a second class of stock. All owners need to contribute and distribute pro rata to ownership, so if you have one partner contributing funds and the other contributing time, you have a problem and can’t do an S-Corp.
- Exposure Area: Reasonable Compensation – The IRS is critical of this piece so keep that in mind, you can go under audit and the IRS can argue you’re underpaying yourself, and when the IRS asks for tax in arrears, the amount due is usually going to double from what it would have been due to interest and penalties, and then tax professional fees in defending the position
- Exposure Area: Tax Basis Tracking – You want to be keeping track of your tax basis always and don’t assume your preparer is necessarily doing it for you, since a lot of them don’t clearly understand it in the first place. Especially if you have switched preparers while having your business, that basis number is cumulative and often gets lost between moving from one preparer to the next.
So there you have it. We went over the reason you can save tax with an S-Corp but also the areas to look out for. S-Corps are really common but that doesn’t mean they’re simple, which is why I also spoke at a conference with business attorneys to explain the process, especially situations where you can terminate your S-Corp inadvertently and then it becomes a C-Corp, and the video to that talk is linked above.
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Disclaimer: This information on this website is for educational purposes only and does not constitute professional legal or tax advice.