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How To Save Taxes By Setting Up S-Corp

  Sanjiv Gupta CPA  Published 
How To Save Taxes By Setting Up S-Corp

How to Save Taxes as an S-Corporation

If the individual is self-employed, it is possible to help avoid high Medicare and Social Security taxes to organize the business as some kind of S-corporation. This is because individuals who are not hired by any corporation must pay higher Medicare and Social Security. By organizing the business as some kind of S-corporation, then having higher taxes can be avoided.

The IRS or the Internal Revenue Service can also take a close look at the taxes if this route is chosen as it could also lower the overall tax liability and then generating a similar net income.

Self-Employment Taxes

Whether the individual is an employee or self-employed, they still have to pay Medicare and Social Security taxes to the government. When working for someone else, the individual is only responsible for his share of the taxes and the employer can make the difference by paying the balance off. However, for those who are self-employed, they are expected to pay both the portions of the tax. The combined employer and employee portions of this tax usually amount to a total of 15.3 percent.

S-Corp Distributions

If the business is organized as some kind of S-corporation, then it is possible to classify some of the incurred income like a salary and some of these as a distribution.  The individual is still liable for the self-employment taxes on the salary portion of the income, but they just have to pay the average income tax on the distribution portion. It also depends on how the income is divided. In doing so, it can save a substantial amount of the self-employment taxes by merely converting this into the S-corporation.

The Risks of Filing the Business as an S-Corporation

The Internal Revenue System or the IRS looks closely at the S-corporation returns because it has more potential to be taken advantage of. Take this situation for example. An entrepreneur who generates an annual income of $500,000 abuts only records $20,000 will trigger an inquiry from the IRS because he is obviously avoiding many self-employed taxes. The guiding principle is that the taxpayer must designate an amount that is reasonable to his income. However, this is quite a gray area and if the envelope is pushed too far, then there is more risk for the IRS to do an audit and also start of potential penalties on the interest of the back taxes that the IRS have already addressed.

Additional costs for S-Corporations

The S-Corporation saves the individual from self-employment taxes. It also costs the individual more than he can save. With larger corporations, the S-corporation is some start-up that has accounting and legal costs. There are some states that are expected to pay more taxes and fees. Take for example the S-corporation in California must pay 1.5% on the income and a minimum annual amount of $800. This is not a requirement for sole proprietors.

Difference Between S Corp and LLC

Both the S-corp and the LLC provide the entrepreneur with a similar kind of protection. However, the LLC is much simpler than the S-corp. Filing it as LLC can also save the taxpayer a couple of thousand dollars especially on the cost of administration. However, studies show that there is more money saved when incorporating. This is because of the differential in the Medicare tax.

It is important to note that the profits from the LLC are taxed completely for FICA, which is Medicare and Social Security combined. This means 15.3% of the FICA taxes along with the additional $2.9 Medicare taxes on the profits that are above the wage base.

This is where the difference between the S-profits comes in. An S-Corporation is not taxed for FICA. This is the differential in Medicare. Under normal circumstances, full-time physicians usually earn more than what they get from the wage base of Social Security. The tax savings are also generated from the Medicare differential between the non-taxed profits of the S-corps and the fully taxed profits of the LLC.

The catch is when the entrepreneur incorporates then he is both the owner and employee of the corporation. As the corporate owner, the taxpayer hires himself, who is also the employee. The upside is that the LLC is some kind of venue where the taxpayer is both the worker bee and the business owner. Therefore, the business results of the LLC when reported and filed on Schedule C that also includes the individual’s 1040, there is no separate income. This then saves him money.

Receiving Remuneration from S-Corp in Two Ways:

  • As an employee, the taxpayer receives a “fair salary” by the corporation because he is productive.
  • As the owner, the taxpayer pays himself a “distribution” of the said profits that remain after every other expense (including the salary of the taxpayer). These profits are also taxable because it is income and not because it is considered as Medicare taxes.

For S-Corp to make sense financially, the individual must have profits that are significant and long-lasting even after the salary of the employees have been paid fair and square. How is a fair salary calculated? Here are two ways:

  • The IRS typically does not challenge the “fairness” of the salary if it is not equal to the remaining profits even after paying one’s self.
  • The entrepreneur must also pay a reasonable amount depending on one’s production, location, and profession.

The salary being reasonable is constantly scrutinized by the Internal Revenue System. This is because of the owners of S-corp are tempted to earn their remaining profits from the Medicare taxes because all year round, they were only getting a minuscule paycheck.

Business owners and self-made entrepreneurs must understand that S corporations can save owners tax when registered as a small business. There is a big benefit for the entrepreneur if they list the business down as an S corporation. The S corporation minimizes employment taxes.

However, it must be clarified that the S corporation is not really a corporation. Instead, an S corporation is actually a limited liability company that is strictly made for the Subchapter S election.

People including tax accountants regard this as “S corporation.” However, the more proper way of calling it is Subchapter S corporations especially when the entity that is making the election is a “Subchapter S LLC.” It only comes to show that the entity that makes the election is really an LLC.

Here is a more elaborate explanation on how the Subchapter S allows the business owners to save more money:

Avoiding Some Taxes

The S corporation election lets the business owner avoid Medicare, self-employment taxes and Social Security on the portion of the business profits. That is the deal as well as the trick. The tax avoidance gambit also works quite simply despite it being regularly debated by the Congress and also reaffirm the works.

With an S corporation, the entrepreneur splits the business profits into two: “distributive share” and “shareholder wages.” The shareholder wages are subjected to 15.3% tax and the leftover distributive share cannot be subject to 15.3%.

Tax accountants really do not explain this and can be quite sheepish on this particular subject matter. However, for entrepreneurs who wish to avoid Medicare and Social Security taxes along with the self-employment taxes, it is definitely beneficial for them to be listed as an S corporation.

Note that the S corporation also lets the active shareholders to not pay the surtax of 3.8% for Medicare on business profits.

The Deductible Losses for Smaller S Corporations

As mentioned in the previous paragraphs, the saving tax loophole on taxes that are associated with the S corporation passes by S corporations that let the shareholder, as well as the employee, avoid the employment taxes. This is where entrepreneurs and self-employed individuals must focus on if they wish to make a Subchapter S election for their LLC or their corporation.

However, there are also two smaller general tax benefits that are associated with the S corporation. The first benefit is that the S corporation tends to lose money and that loss eventually becomes a tax deduction on the individual tax return of the shareholder.

There are some rules that the entrepreneur must follow in order to deduct these losses. In summation, the money that is lost must be the money of the beneficiary. They must also be working in the S corporation. This is a good benefit for businesses that experience losses whenever they ramp up.

Another benefit is that the minor tax savings can also flow from the Subchapter S status. An S corporation has a safer tax return that can put deductions. This results in entrepreneurs claiming deductions that are legitimate.

No Corporate Income Tax

Another tax-saving benefit that must be delivered by S corporations is a special case and is only applicable to businesses that are operated in the form of regular corporations. These are also regarded as C corporations.

In most situations, the S corporation does not pay corporate income tax. This means that when compared side by side with the C corporation, the S corporation can pretty much save the entrepreneur a corporate income tax.

With the examples presented above, it only makes sense that it is definitely fair for the entrepreneur to tax these small business corporations at a 63% tax rate. It is also self-evident that a corporation should be elected and treated as an S corporation. This is because as S corporation, there is no income tax that can be levied. Whenever the income is allocated to the individual shareholders, there is a maximum rate of 44%. This means that it would be around $440,000 in the form of income taxes and then it would be around $600,000 leftover right after the tax profit.

Year-End Tax Planning for S Corporations

 Businessmen and entrepreneurs work hard on preparing and planning for the upcoming tax season. An area that must be paid significant attention is how to properly plan for the S-Corporation clients. This is because the S-corporation is a designation within the IRS tax code which also changes how corporations are taxed. If the corporation is created within the state law and it is applicable, then it is granted the S Corporation status from the IRS. The business is no longer taxed as a corporation and this is good news for the owner because they receive lower tax rates. In the long run, it transforms into a “flow-through” entity and its earnings accumulated from the corporation are eventually taxed at the level of shareholder and listed as-is on the 1040 tax return. There are also other entities that are requested and treated as the S Corporation for the taxes whereas the remaining amount is simply for the LLC and its legality.

There are also several aspects that are connected to S corporations and must be specially planned toward the end of the year. When Congress enacted the statutes of the S-Corporation, there have been lots of quirks and this was created and it primarily affected the S-Corporations. It eventually seemed inconsistent along with the other areas from the tax code. Nonetheless, it requires that this may be properly accounted for.

Salary of the Owner

The profits of partnerships, LLCs and sole proprietorships are subjected to two taxes: self-employment taxes and income taxes. When one of these two is treated as some kind of S-corporation. The residual profits are not subjected to taxes for the self-employed. This can definitely decrease taxes. This is somehow true to a certain degree. Offsetting the tax savings is the very reason why an owner of an S-corporation must pay himself or herself a salary that is within the means to commensurate services that have been provided to corporations. The salary is then subjected to employment taxes. In effect, the portion of the residual profits of corporations is not allocated to salaries subjected to self-employment taxes.