When you start your own business, you have a plethora of options for the type of entity you would like to operate as. Just to name a few, you can be a sole proprietor, incorporate as an LLC, be a C corporation or be a partnership (if you have a business partner). All of these choices can make you more confused than a homeless man on house arrest.
What makes matters worse is that this choice has huge consequences to your bottom line. Choosing the wrong entity can lead to dire consequences. One choice that should definitely be on your radar is the S Corporation.
You may be wondering what exactly an S Corporation is. Well, it’s basically a kind of entity that only exists for tax purposes. For all other purposes, it’s a different type of entity.
Confused yet? Allow me to explain: You know that annoying friend you have on Facebook who dominates your feed with annoying posts like, “I have the best wife. She’s my best friend and partner in crime <3.” Or “Feeling blessed—my kids never fight and I never have to yell at them #soblessed #neverfight #neveryell #hashtag.”
You probably assume that this annoying friend is so happy, right? Think again. Recent psychological studies have shown that people who constantly post about how great their lives are on social media are actually quite insecure and unhappy. The reason they post is because it’s easy to pretend everything is great in this fake, virtual world. Also, the comments people leave for them provide a boost to their self-esteem. So, things may not be great with Shmoopie at home, but by pretending that they are, he can feel better. You just didn’t see that person yelling at their kids to shut up, stop fighting and look happy for the picture, so he can post #mylittleangels.
What’s my point with this nonsense? The S Corporation is similar to these annoying Facebook posters. These people create this virtual utopian life where they are completely happy and present it to the world to see. And for the most part it works—we believe it. An S Corporation is really just a tax concept. Your legal entity is really just an LLC or C Corporation, but you can elect something called “S Corporation status” with the IRS and state. They allow you to pretend to be something that you’re really not, and it could save you thousands of dollars.
For tax purposes, the S Corporation is a pass-thru entity, meaning that the corporation’s income, deductions and tax credits are passed down to you, the shareholder, on a K-1. The huge advantage to an S Corporation is the ability to save on Social Security and Medicare taxes (aka self-employment taxes).
This is how you can save: Even though you are the owner of an S Corporation, you are also an employee. As an employee, you pay yourself a salary to compensate you for the work you do in the business. The wages are subject to Social Security and Medicare taxes. The rest of the profits can be taken out as distributions, which are not subject to Social Security and Medicare taxes. These taxes are a whopping 15.3 percent!
If you operate as a sole proprietor (or LLC taxed as a sole proprietor) then you pay Social Security and Medicare taxes on your entire profit. Let’s look at a quick example to see how an S Corporation can save you big money.
Let’s say you earn $150,000 net profit in your business in 2017.
If you operate as a sole proprietor, you pay $19,790 in Social Security and Medicare taxes.
If you operate as an S Corporation and take a salary of $50,000, you will pay only $7,650 in Social Security and Medicare taxes. You can still take out the remaining $100,000 profit from the company, but without paying Social Security and Medicare taxes on it.
The S Corporation saves you $12,140 in self-employment taxes!!!
There are various considerations to account for before deciding if an S Corporation is right for your business, so speak to your accountant to see if it makes sense for you. You may just find yourself saving thousands in taxes with an S Corporation.
By Daniel Magence
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.