Reduce Your Self-Employment Taxes with an S Corp
Being self-employed is great in so many ways. You have a flexible schedule, you can choose your own clients and of course you get to keep all the upside from your hard work. One big drawback though are the self-employment taxes that you owe every quarter.
Thankfully there’s a fairly simple way to avoid those – setting up your small business as an S corp (or converting your existing LLC into an S corp). Let’s walk through all of the details of this cool tax savings strategy!
S Corp vs. C Corp vs. LLC
We’ll start with the basics. When you establish a corporation, you are separating yourself from your business by creating two distinct entities — you and the business. There are three main types of business entities you can choose between – an S corporation, an LLC or C corporation.
An LLC is often the choice for self-employed individuals since the current tax law allows you to “pass through” income. This means that you can report your small business income directly on your personal tax return and not file a separate tax return for your single-member LLC. This helps you avoid the double taxation that C corp shareholders have to pay (with a C corp, the business pays taxes on any earnings first and then you as the shareholder also pay another tax when you take money out in the form of a shareholder distribution).
While setting up as an LLC eliminates the C corp double taxation, it comes with one big caveat – you still have to pay self-employment taxes. The third option for legal structure – an S corp – gives you the best of both worlds.
Since an S corporation is treated as a pass-through entity (similar to an LLC), the government does not tax S corporations. Instead, the profits of the business get split among the shareholders, who then pay personal income tax on the distribution.
The important thing to note and remember is that these profits that you take out of your S corp aren’t subject to self-employment taxes. Therefore you want to maximize your distributions from your S corp to the fullest extent possible.
Here we must insert a word of warning. If you set up an S Corp and take only a very small salary or none at all, you can just pay yourself in dividends and avoid self-employment taxation altogether, right?
Not so fast. Unfortunately, the IRS is also savvy, and they’re onto this trick. The IRS demands that you give yourself a reasonable salary throughout the year. A reasonable salary is essentially one that you would earn if you were doing the same job for another company.
Let’s say, for example, that you operate an S corporation where you work as a consultant. Your plan is to pay yourself a $40,000 salary this year and then take any dividends to which you are entitled. After doing a little research, however, you discover that the average salary of a consultant in your area is $60,000. The IRS expects you to take a salary closer to the $60,000 average and pay self-employment taxes on that salary.
Still, if you’re making anything north of $60,000, then setting up as an S corp allows you to avoid the self-employment tax on the excess earnings above $60,000. Since it’s currently a 15.3% tax rate, this can add up quick!
Tax Forms for S Corporations
So how does all this actually work come tax time? The first thing you’ll want to do at the end of the year is to prepare all of the financial statements for your company. You’ll need information from your profit and loss sheet as well as your balance sheet to complete the next steps in the process.
Your next step is to prepare and issue W-2’s. As usual, your employees (yourself included), the Social Security Administration, and state and local governments all get copies.
Now you’ll prepare and file an IRS Form 1120-S (Pro tip: the Form 1120-S closely resembles the Form 1120 used by C corporations, so make sure you have the right one.) and distribute a Schedule K and a Schedule K-1 to each of your shareholders. This critical paperwork reports distributions to the company’s stockholders so they know how much taxable dividend money they received from the company.
After you’ve filed and distributed the business return and forms, you can turn your attention to your own personal taxes and file your Form 1040. When you do, you’ll pay taxes on your wages and on the dividends you received as a shareholder. Remember to file a Schedule E and Schedule 1 with your personal tax return.
S Corp Election Conclusion
If your business is eligible for S corporation status, it may very much benefit you to take advantage of it. Like all tax choices, however, this election has rules you need to follow and consequences you need to be aware of. Even if you fully understand s corp taxes, the actual filing procedure for shareholders in S corporations is quite complicated.
If you’ve got it all down, our hats are off to you — this is some pretty heavy stuff. But if you need a little help to make sure you’ve crossed all the T’s and dotted all the I’s, we feel you. The professional CPA’s at Picnic Tax are here to help you sort it all out. It’s what we do, and we love doing it.
We’ve got your back, and we can help you with everything from setting up your S corp, making sure your salary meets the IRS requirements to checking that you’ve properly filled out your Form 1120-S. Give us a call today and sleep a little easier knowing you’re doing everything you can to reduce your self-employment taxes.