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How to Save Taxes with an S Corporation
How to Save Taxes with an S Corporation
Ever wondered why so many small businesses--more than 3,000,000
at last count--operate as an S corporation? Simple. An S
corporation saves business owners big taxes in three separate
ways:
First, as compared to regular corporations (sometimes called C
corporations), S corporation owners can use the business's
losses incurred during the early lean years on the owner's
personal returns as deductions.
For example, suppose a new S corporation suffers a $20,000 loss
its first year and that the corporation is equally owned by two
shareholder-employees, Smith and Jones. Smith and Jones each get
a $10,000 business deduction on their individual tax returns
because of the S corporation loss. This $10,000 deduction might
save them each as much as $4,000 in federal and state income
taxes.
A second, big S corporation benefit: As compared to almost
every other business form, S corporations can save their owners
self-employment or Social Security/Medicare taxes.
Suppose, for example, that Adams, Brown and Cole independently
each own businesses that make $90,000 a year in profits. Each
business owner may pay $13,000 in income taxes. But,
unfortunately, that's not the only tax they pay. Each owner also
pays self-employment or Social Security/Medicare taxes.
For example, Adams operates his business as an LLC and
therefore pays 15.3%, or roughly $13,500, in self-employment
taxes on his profits.
Brown operates his business as a C corporation which pays all
of its profits to him as a salary. Accordingly, Brown (through
his corporation) also pays 15.3%, or roughly $13,500, in Social
Security and Medicare taxes.
Cole's situation is different. Cole operates his business as an
S corporation which means that Cole can split his $90,000 of
profits into two payment amounts: salary and S corporation
distributions.
Suppose that Cole says only $40,000 of his profits are salary
and takes the other $50,000 as a "dividend" distrbution. In this
case, Carter pays the 15.3% Social Security/Medicare tax only on
the $40,000 in salary. Carter therefore pays roughly $6,000 in
Social Security/Medicare taxes--and annually saves $7,000 in
taxes as compared to Adams or Brown.
S corporations also, sometimes, provide a third form of tax
savings because S corporations don't pay corporate income taxes.
This means that S corporations avoid the often-talked about
"double-taxation" problem. However, the "no corporate income
taxes" benefit often isn't a savings for small corporations and
their owners.
But let me explain. Suppose that two corporations each earn the
same pretax profit of $100,000 and are owned by Ms. DaVinci who
pays the highest federal income tax rate of 35%. One corporation
is an S corporation and the other is a C corporation.
The S corporation can distribute the entire $100,000 in profits
to DaVinci as dividends because there is no corporate income
tax. DaVinci then pays $35,000 in personal income taxes on the S
corporation profits, which means she nets $65,000 in after-tax
profits from the S corporation.
In comparison, the C corporation can't pay the entire $100,000
in profits to DaVinci. The C corporation first pays $22,250 in
corporate income taxes. When the C corporation pays the
remaining $77,750 to DaVinci as a dividend, DaVinci pays another
$11,663 in 15% "dividend" taxes on the C corporation profits.
This means that DaVinci nets roughly $66,000 in after-tax
profits from the C corporation profits. In this case, DaVinci
saves money with a C corporation in spite of having to pay the
corporate income tax.
How to Get S Corporation Benefits
To create an S corporation and receive S corporation tax
savings, you need to do two things: First, you must incorporate
the business either as a regular corporation or as a limited
liability company. Second, you need to make an election with the
IRS to have the corporation or LLC treated as an S corporation.
The S election is made with form 2553, available from the
www.irs.gov web site. Note that some states (such as New York)
require a separate state S election.
A final tip: S corporations can save you thousands of dollars
annually, but your tax savings can't start until you elect S
corporation status. If you're interested is electing S status to
save on taxes for next year, you may want to call your tax
advisor or attorney right now!
About the author:
Bellevue WA CPA Stephen
L. Nelson is the author of both Quicken for Dummies and
QuickBooks for Dummies and an adjunct tax professor for Golden
Gate University's graduate tax school.
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