S-Corporation Tax Savings
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One of the biggest benefits of the S-Corporation tax election is the potential to save money on your tax return. But, how do you save money on your taxes with an S-Corporation? Let’s take a look at it in more detail.
Operating an S-Corporation Can Lower Employment Tax Liability
In addition to paying Federal income tax, everyone must also pay some type of employment tax on their earnings over the course of the year.
If you own a business as a sole proprietor or single-member LLC, your ENTIRE business income is subject to self-employment tax (currently 15.3%) AND Federal income tax. So, you could easily pay an average of 40% (15.3% in self-employment tax + 24% in Federal income tax) on ALL your net business income.
Operating as an S-Corporation provides a way to REDUCE the amount of self-employment tax that the owner (you) pay. The S-Corporation SPLITS UP the net economic benefit to the owner (you) in two ways:
Salary: Employment taxes must be paid on amounts received as salary.
Dividends: No employment tax is due on amounts received as dividends.
By utilizing a combination of dividends and salary, an S -Corporation owner can reduce self-employment tax liability and generate wages-paid deductions that will reduce the amount of corporate income. This is also a main difference between the taxation as an S-Corporation and taxation as an LLC/sole proprietor. LLC members/sole proprietors are considered owners, but not employees.
The S corporation’s allocation between salary and dividends must be reasonable. That is, the salary must be in line with what would be paid for comparable work performed by an individual with comparable skills and experience. The IRS closely scrutinizes transactions between shareholders and their S corporation — especially if those transactions have tax avoidance potential like an unreasonably low salary to avoid employment taxes.
Analysis of S-Corporation Savings
Let’s look at some numbers to see what your savings could look like when electing to be taxed as an S-Corporation versus remaining an LLC taxed as a sole proprietor. These are based on using a salary of 50% of net ordinary business income after expenses and deductions for amounts up to $200,000.
Chart Notes:
Social Security taxes of 12.4% stop at $147,000 (for the 2022 tax year) of net ordinary business income for LLCs/sole proprietor/partnersip. It also stops at $147,000 for S-Corporation employee salaries.
Medicare taxes of 2.9% continues into perpetuity (no limit).
Savings as a percentage of income starts to drop off at $147,000 which makes sense given the Social Security cap for the 2022 tax year.
The Medicare surtax starts for those earning $200,000 and filing single, and $250,000 for those filing jointly. Contact us to model out your specific tax savings if this applies to you.
Let’s walk through what the table shows.
We’ll focus on the fourth row that starts with $100,000.
What this row shows us is that your business is making a net income of $100,000.
The second column titled Total SE Tax shows the amount of taxes you owe if your company is an LLC taxed as a sole proprietor. Under this tax structure, you’ll be paying self-employment taxes on your total income which equals $14,130.
The fourth column titled Total Payroll Tax shows how much you owe in taxes if your business is an LLC taxed as an S-Corporation. Under this tax structure, you’ll only have payroll taxes on your Salary in the third column. As an S-Corporation, you would owe $7,650
The difference is shown in the fifth column titled Savings. Your savings paying taxes as an S-Corporation is $6,480!
Keep in mind this simple example shows your potential difference in savings on your taxes and doesn’t take into account the additional costs invloved in operating an S-Corporation.
The S-Corporation Money Trail
The chart below shows the difference between how your income is taxed when it’s in an LLC taxed as a sole proprietorship VERSUS taxed as an S-Corporation.
The four boxes on the LEFT is the money trail of your LLC taxed as a sole proprietorship.
The series of boxes on the RIGHT is the money trail of your entity being taxed as an S-Corporation.
Note the $60,000 chunk of income on the far right hand side that is not being taxed at the self-employment tax level. This is the source of your savings!
Also note that the entire $100,000 is being subjected to Federal income taxes for both the LLC taxed as sole propreitorship AND the S-Corporation .
This is a common misconception that there is a Federal income tax reduction with an S-Corporation election. Not true. The ONLY reduction is in self-employment taxes. All other tax deductions such as operating expenses, home office expense, mileage, meals, 401k plans, etc. are equally deductible with or without an S-Corporation.
LEFT - LLC taxed as a sole proprietorship
It shows your business makes $100,000 net income.
All $100,000 is subjected to self-employment taxes at 15.3%.
Additionally, that same $100,000 income is subjected to Federal income taxes.
RIGHT -
LLC taxed as an S-Corporation.
It shows your business having the same net income of $100,000, but you decide to pay yourself a reasonable salary of $40,000.
The $40,000 salary has employment taxes withheld. This
$40,000 is reported on a W-2 and taxed at Federal income tax rates.
The other $60,000 in income could be taken as a distribution. It is only subjected Federal income taxes.
Conclusion
It is unwise to select a business structure based solely on tax considerations, but it is also unwise to neglect to consider the tax impact of your decision. The combination of pass-through taxation, which eliminates risk of double taxation, and the ability to receive both salary and dividends can make the S-Corporation a good choice from a tax perspective.
However, it is wise to discuss all your options, including your long-range growth plans, with your business advisors before making the S corporation election.