When you are self-employed, oftentimes you end up having to pay higher Social Security and Medicare taxes (collectively known as self-employment taxes) than if you were merely an employee of a company. However, a solution exists to help you avoid these higher taxes by organizing your business as an S-corporation. By establishing a separate legal entity, an S-corporation lets you avoid filing your business income on Schedule C of your 1040 (as you would if you operate as a sole proprietor or if your limited liability company is taxed as a disregarded entity). Why does this matter?
Regardless of whether you are self-employed or an employee, you are required to pay Social Security and Medicare taxes. However, as an employee, you are only responsible for part of these taxes, while your employer pays the balance. In contrast, when you are self-employed, you have to pay the entire tax. The combined employee and employer portions of this tax amount normally amounts to 15.3%.
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You are still liable for self-employment taxes on the salary portion of your income, but you only pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation. The key is paying yourself a “reasonable” salary.
Risks of S-Corporations
The IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $500,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a “reasonable” amount of your income as wages, rather than a distribution. What constitutes “reasonable” can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.
Additional costs for S-Corporations
While an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs.
If you currently operate your business as a sole proprietorship and would like to save money on your taxes, contact our office to discuss how we can reorganize your business to save you money.