Close

Tax Services

Our Ironclad Guarantee

Here at Legacy Tax & Resolution Services, we not only stand behind our services but we spell it out with a 5 star, top notch customer guarantee

View page

Switch to S Corporation Taxation Could Save You $5000 or More When Compared to Operating as a Sole Proprietor

Switch to S Corporation Taxation Could Save You $5000 or More When Compared to Operating as a Sole Proprietor. Note: This would be on an Annual Basis! Regarding legal entities for a small business, Subchapter S Corporations (S Corps) are the new kids on the block. Thanks to the 2018 tax reform, people are scrambling to start S corps because of the potential tax savings for business owners. The first thing you should know about S corps is that they ARE really cool—but not too cool for you. The second? They’re popular for a reason. Converting your business to an S Corp or starting one can save you serious taxes. Yep, there’s more to tax rules for S corps than meets the eye. S Corps, Defined As an owner of an S Corp, you receive something called limited liability protection. This means you’re not personally responsible for any debts or liabilities for the business since it’s separate from you as a person. This helps to protect your personal assets if your company is ever sued. S corps are considered pass-through entity, which means that your S Corp doesn’t pay taxes on the profits it earns—you, as the owner, do. Unlike C corporations (C Corps), where both the business and owners pay income taxes, an S Corp avoids double taxation as a pass-through entity. For this article, we will focus on The Single-Owner S Corps. Entity Type Owner Pays Taxes Business Pays Taxes Sole proprietorship X LLC X Partnership X S corp X C corp X X The Catch and the Savior The catch! S Corporation owners are required to pay a “Reasonable Salary” as an employee, and that Salary is subject to payroll taxes (more on this below). S Corp owners must also pay taxes on the company profits, even if you leave them in the corporation and don’t take them as a distribution, which for S Corps is usually not in the form of dividends. The Savior! S Corporation owners must pay payroll taxes ONLY on the “Reasonable Salary.” Compare that to the sole proprietorship that must pay Self-Employment taxes on the ENTIRE net profit of the business. Below is an example of how you can save money Sole Prop/ LLC S Corp Total Annual Revenue $168,000.00 $168,000.00 Annual Business Expenses $30,000.00 $35,000.00 Annual Business Salary $53,200.00 Payroll Taxes (FICA) $4,069.80 Payroll Taxes (FUTA) $434.00 Net Income $138,000.00 $75,296.20 Your Portion of Payroll Taxes $19,498.78 $4,069.80 Total Payroll Taxes Paid $19,498.78 $8,573.60 Payroll Tax Savings $10,925.18 Sole proprietors get hurt by the tax laws, mostly because they don't know any better. Fact: Most freelancers—we’re talking over 80%—are classified as sole proprietors. Basically, you automatically become a sole proprietor if you start a one-owner business and don’t form a business entity, such as a limited liability company (LLC) or corporation. And because sole proprietorships are easy and cheap to run, they’re popular with freelancer. Note: Even if you form a single-member LLC, by default the IRS will classify you as a sole proprietorship. Result: You have set up an LLC, but from a taxing standpoint, you have not changed anything! Here’s how taxes work when you’re a sole proprietor: You and your business are considered one and the same for tax purposes You don’t pay taxes or file tax returns separately; you file one return. You report any income you earn and losses you incur on your personal tax return (IRS Form 1040) If you profit from your business, you add that money to any other income you've made, such as interest or your spouse's income if you're married and filing jointly.. If you incur a loss, you can use it to offset income from other sources Once you add up all of your earnings from all sources, that becomes the total that’s taxed at your personal tax rate. Straightforward enough, right? It's clear that being a sole proprietor isn't bad when it comes to income taxes. The problem is that income taxes are only part of the story. You also have to pay self-employment taxes on your net self-employment earnings, which consist of two separate taxes: Social Security tax and Medicare tax (the same Social Security and Medicare taxes that employees and employers pay). Let’s break it all down: 1. Social Security tax is 12.4% (up to an annual income ceiling). Net self-employment earnings (or employee wage income) over the ceiling aren’t subject to the tax. What’s the ceiling for 2019? It’s $132,900. So, if you earn precisely $132,900, you’ll pay $16,478 in Social Security tax. If you earn more than $132,900, you’ll still pay $16,478. If you earn less than $132,900, you’ll pay less than $16,478. But $16,478 is the maximum you must pay, no matter how big your income. 2. Medicare tax is 2.9% up to an annual ceiling of $200,000 for single taxpayers and $250,000 for married couples filing jointly. Anyone who earns more must pay a 3.8% tax on income that exceeds the ceiling—in other words, that income will be subject to an additional 0.9% Medicare tax. 3. The combined Social Security and Medicare tax is 15.3%. However, the "effective" tax rate is a bit lower thanks to certain deductions. So, what do we mean when we say that sole proprietors get hurt by the tax laws? Well, a lot of freelancers pay more Social Security and Medicare taxes than they do income tax. Plus, they must pay all those taxes themselves, unlike employees who only have to pay half because their employers cover the other half. To put things in perspective, employees only pay a maximum of 7.65% in Social Security and Medicare tax, while freelancers pay 15.3%. It's a downer. The privilege of working as a sole proprietor comes with some severe tax burdens. Not cool. But, before you decide to get out of business, know that there are ways to save, and we cover that below. If you’d like to see how much you could save on taxes, we’ve developed an S Corp tax savings calculator to determine your potential tax savings. How S Corps save you money on taxes Even if you’re running a one-person business, you don’t have to be a sole proprietor; instead, you can form a corporation or limited liability company and have it taxed as an S Corp. An entity is indeed more expensive to form and run than a sole proprietorship. But it provides substantial savings regarding your Social Security and Medicare taxes. Here’s what happens after you form an S Corp: You won’t personally own your business anymore. Instead, it will be owned by your corporation or LLC, providing you with limited liability. With liability protection, you generally won’t be personally liable for your business’s debts or lawsuits. You don't get limited liability when working as a sole proprietor; sole proprietors are personally liable for everything. As a pass-through entity, your S Corp doesn’t pay taxes Any business profits or losses are passed through to you, the owner, in proportion to your share ownership. You file everything on your personal tax return and are taxed at your individual income tax rate. For example, if you’re the only shareholder, all of the profits or losses of your business will go to you, and you pay income taxes on them, just like when you were working as a sole proprietor. But there’s one significant difference: You’ll become an employee of your S Corp, which means you’ll be the sole shareholder (owner) and an employee. As an employee, your S Corp must withhold federal income and employment (Social Security and Medicare) taxes from your employee wages and pay state and federal payroll taxes on your behalf. Remember: you’re the employee, and your S Corp is your employer. You’ll each pay half of the Social Security and Medicare taxes due on your wages, and then your business gets to deduct your salary and its portion of payroll taxes. There’s no employment tax on S Corp distributions. A key thing to understand about S Corps is that you don’t pay employment tax on distributions from the business. A distribution is earnings and profits that pass through the corporation to you, the owner. Basically, it’s what you earn outside of your employee wages. So, the larger your distribution, the less employment tax you’ll pay. Pretty sweet, right? Note: The S Corp is the only business entity that allows its owners to save on employment taxes. This is the main reason why S Corps are extremely popular with intelligent business owners. If you weren't paid any employee wages, you wouldn't have to pay any employment taxes. But, as you probably already expected, this isn't allowed. The IRS requires that an S Corp shareholder-employee pay themselves a reasonable salary—at least what other businesses pay for similar services. What counts as a reasonable salary varies because there aren’t any precise rules. But, if you pay yourself too little in wages, the IRS can allocate part of your shareholder distribution as wages and require that you pay employment taxes on that. Here’s an example of how it works: James, a consultant, forms an S Corp that earns $100,000 in profit. His corporation pays him $60,000 in employee wages and bonuses. The remaining profits pass through the S Corp and are reported as a distribution on James' personal income tax return (not as employee wages). But because it isn’t viewed as employee wages, neither James nor his corporation pays employment tax on this amount. James and his business only pay $9,100 in employment taxes instead of $15,300. That’s a lot of savings! Examples of S Corp tax savings The more money you pay yourself as a distribution, the more Social Security and Medicare tax you’ll save when you run an S Corp. Likewise, the more profit your business earns, the more you’ll save. To make sense, you need to earn at least $40,000 in profit for an S Corp. Otherwise, the costs of forming and running it exceeds its benefits. Here are some charts that show the tax savings for businesses with $40,000, $80,000, and $100,000 in profit. As you can see, the smaller your employee wages, the more significant your savings will be. The charts also show the savings when 60% and 40% of your business profit is paid to you in wages, with the remainder paid as a shareholder distribution. Sole Proprietor vs. S Corp: $40,000 Profit Sole Proprietor S Corp: 60% Wages/ 40% Distribution S Corp: 40% Wages/ 60% Distribution Total Profit $40,000 $40,000 $40,000 Employee Wages N/A $24,000 $16,000 Social Security tax (12.4%) $4,960 $2,976 $1,984 Medicare Tax (2.9%) $1,160 $696 $464 Federal Unemployment tax $0 $420 $420 Net Tax Payable $6,120 $4,092 $2,868 So what is the Rub? The Salary has to be “Reasonable”. The lower a “Reasonable Salary” that you can set, in comparison to the net profit of the company, the larger the savings. Here are some of the factors the IRS considers to determine whether you’re paying yourself a “Reasonable Salary”: Training and experience Duties and responsibilities Time and effort devoted to the business Dividend history Payments to non-shareholder employees Timing and manner of paying bonuses to key people What comparable companies pay for similar services Compensation agreements Use of a formula to determine compensation. The more significant the disparity between the desired “Reasonable Salary” and the net profit, the more you should consider hiring an independent third-party “Reasonable Officer Compensation” analysis firm to provide you with an audit-ready report to support your “Reasonable Salary.” Note: The S Corp “Reasonable Salary” requirement only comes into play if you (and other shareholders) take distributions from the company’s profits. The IRS can’t impose a minimum salary requirement, so don’t fret if your business isn’t earning enough yet to pay yourself a salary comparable to others in your field. Two Ways Starting an S Corp Can Help Save Money on Taxes; 1. Your business can write off your salary, which lowers your payroll taxes Per the IRS, S Corp owners must pay themselves a “Reasonable Salary” as an employee of their company. Being paid as an employee means that your wages are subject to the Federal Insurance Contributions Act (FICA) payroll tax withholdings (Social Security and Medicare, among other things), AND the S Corp must also pay employer payroll taxes. You’re probably thinking, “I thought you said I was going to save money on taxes—not pay more!” Bear with me. When you’re paid a salary via payroll, two very cool things happen: Your taxes are taken directly out of your paycheck. Instead of getting a giant tax bill at the end of the year, your taxes are deducted every time you get paid. Plus, instead of footing the entire tax bill all at once, your S Corp pays for half of your FICA payroll taxes throughout the year, making your year-end taxes way easier to manage. Your employee payroll taxes and wages are a deduction for the company. Your Salary is a write-off for the corporation, which lowers your overall profit, which reduces your taxes. That's because you're taxed on those profits, so when they're lower, you pay less. Recap: When you pay yourself a salary from your S Corp, you personally get paid. Your income and payroll taxes are deducted directly from your paycheck. (So you don’t have to worry about having enough money to pay them off later.) Your S Corp writes off your salary, and it’s portion of your payroll taxes, which reduces your year-end taxable profits. Now that you're stoked about getting a paycheck from your business let's talk about how you get taxed on the profits from your S Corp. Contrast that to your former life as a sole proprietor: You pay self-employment taxes on the ENTIRE net profit of the business. You must make an estimated payment to get the money into the system to avoid falling short. You have NO CONTROL over the limitation of your self-employment taxes. Now that you're stoked about getting an LLC Taxed as an S Corp set up let's talk about how you get started. Click the link below. Entity Structuring- Document Preparation Quote

View page
 

Track Your Refund

 
Track Federal Refund Check Federal Amended Return Refund

Check your State Refund

Client Login

 

Refer a Friend

.