One of the questions we get from our self-employed and single-member LLC clients is: “I’ve been told that I should be an S-Corporation because it will save me a lot on taxes, should I be doing that?”
Our answer is, “No, probably not. But, let us explain why.”
In essence, the “tax savings” being referred to by your well-meaning friend is a supposed savings in payroll taxes. However, as explained later in this post, this so-called tax-savings no longer exists – at least if you don’t want to be audited. To understand why people think an S-Corporation will save you taxes we need to explain a few things about self-employed individuals versus S-Corporations and how your income from these businesses is reported.
The business income of a self-employed individual is subject of self-employment tax. The FICA portion of the SE tax is paid at a rate of 12.4% on the first $118,500 of income and the Medicare tax is paid at a rate of 2.9% on 100% of the earnings. So, an individual that has $200,000 of income would pay $20,494 of self-employment taxes in addition to their income tax.
Payroll Tax on Wages
If you have an S-Corporation, you are paid wages and any additional income in excess of your wages is reported as S-Corporation income on your tax return. If your S-Corporation pays you wages of $200,000, then the combined FICA and Medicare taxes paid by you and your S-Corporation is $20,494 – the same as if you were self-employed.
So, no tax savings there.
But, here is what people did in the 1980’s. They would incorporate and elect S-Corporation status and pay themselves a low salary – let’s say a $1 (because some people did do this) and then pass the remainder of the S-Corporation earnings out as profits. If this practice were allowed in 2016, this would save you $20,493 in taxes each year.
IT MIGHT ALSO GET YOU AUDITED AND SUBJECT YOU TO NEGLIGENCE PENALTIES…
Unreasonably low compensation paid by S-Corporatoins is one of the top audit issues with the IRS and their computer algorithms review all S-Corporation returns to determine whether there is an unreasonably low amount of compensation reported compared to the total business income earned by the S-Corporation. In the case of a single-owner with no employees it is difficult to make an argument that the income of the S-Corporation was from anything other than the owner’s personal efforts and, therefore, should be reported as wages to the shareholder rather than a distribution of earnings.
Some Additional Things to Think About
Unfortunately, there are some other reasons you may not want to be an S-Corporation. Here are a few:
Additional Costs –
Even after you have paid an attorney a few thousand dollars to set up your S-Corporation you will need to pay someone every year for the following:
Preparation of S-Corporation Tax Return – let’s say between $500 and $1,000 a year, at a minimum,
Preparation and filing of paychecks, quarterly payroll reports, annual payroll filings – let’s say $100 a month or a total of $1,200 a year,
So, you’ve already lost at least 2k of your tax savings.
Reduced Retirement and Tax Savings –
Paying yourself a lower salary via an S-Corporation will (most likely) decrease the amount you can save tax-free for retirement and the reduced deduction for retirement will increase your income taxes
Paying yourself a lower salary via an S-Corporation may also reduce your social security upon retirement
S-Corporations aren’t bad per se, but the reason to convert to an S-Corporation if you are self-employed is not to save payroll taxes. S-Corporations have their place in the tax planning world, and, in appropriate situations can save the owners a lot on taxes. This situation, even though it’s wonderful talk at cocktail parties and on radio ads, isn’t one of them.