Should I use an S-Corporation to lower my taxes?

Proper entity selection is an important aspect of tax planning. It can help business owners reduce their tax burden significantly every year. The simplest entity choice is a sole proprietorship. As a sole proprietor (a company owned by a single owner or married couple), business income is reported on a schedule C attached to their 1040. There is no requirement to file a separate business tax return, which saves time and money. However, a sole proprietorship isn’t necessarily the best entity choice to maximize tax savings.

All of Schedule C business income is subject to payroll taxes, both Social Security and Medicare, as well as regular income taxes. Social Security and Medicare taxes are a combined rate of 15.3%. These additional taxes can be substantial and are included on an owner’s 1040.

A S-Corporation is a separate entity that files its own tax return and issues a pass through statement called a K-1 to the owners. The K-1 (much like a W-2) is meant to report to the owner their share of income to be included on their personal return. Owner’s continue to report all the income from the S-Corp on their personal return and to pay all the income taxes.

The way S-Corps may save taxes for a business owner is by reducing the amount of income subject to payroll taxes. Unlike schedule C filers, S-Corp owners don’t have to pay payroll taxes on business income. Instead S-Corps have to pay owners a reasonable salary, which is subject to payroll taxes. The following is a simplified example of how a business, making $100,000 a year, maybe reported and save on payroll taxes.

Schedule C Filer S-Corp Filer

Taxable Income $100,000 $100,000

Less: Owner’s Wages (must be reasonable) n/a -25,000

Business Income Reported $100,000 $75,000

Income Reported on 1040:

Business Income $100,000 $75,000

Owner’s Wages (W-2) -0- 25,000

Income subject to Federal Income Tax $100,000 $100,000 (no difference between entities)

Income Subject to Payroll Taxes $100,000 $25,000 (Potential Tax savings is on the income subject to payroll taxes)

A major component of this calculation is the owner’s salary. The IRS requires owner’s wages to be reasonable based on factors such as duties performed and average hours worked per week. The Doty Group offers reasonable compensation reports based on the IRS’ own studies and data. Speak to a Doty Group CPA if you are interested in having a personalized report prepared which can be used to support your salary if ever audited.

While the tax savings maybe enticing, other things to consider are the additional costs associated with the initial setup, the filing of an additional annual income tax return and the cost/time associated with running payroll and filing payroll returns (especially if the entity doesn’t have any other employees). Another factor that can have a big impact is the qualified business income deduction created in 2017 with the Tax Cuts and Jobs Act. A S-election may have a positive or negative impact on the businesses ability to take full advantage of the 20% deduction depending on their industry, income level and employee wages paid.

Tax situations are rarely as simple as those mentioned above. If you are a business owner considering forming an S-Corporation you should consult your tax advisor for a cost/benefit analysis. The Doty Group can provide you with an illustration of your potential tax savings and the estimated cost associated with the change. This will allow you to make an educated decision and know you’ve picked the best path for your business.