The top two benefits of forming a S-corporation over sole-proprietorship are as follows:
- Set aside your investment into a separate legal entity to limit your liability
- Saving employment taxes (it could be widely named as self-employment tax, social security, medicare, or payroll taxes etc)
In order to get the above benefits, you need to spend sone time and effort to achieve them.
(1) To maintain the S-corporation properly and avoid from piercing the corporation veil, you have to keep proper document such as minute, corporate kit, accounting records etc. You may want to get more tips from attorney.
(2) I am writing to talk about how you can save employment taxes.
Assume you make $100,000 before paying yourself as a sole proprietor or LLC, the whole $100,000 is subject to two types of taxes: (1) Income tax, (2) Employment taxes. Since you are serving dual roles as employer and employee, the rate of employment tax is double to about 12% after certain deduction.
If your tax bracket is about 30%, you will end up paying about 42% by adding the employment tax. The tax is about $42,000 in our example above.
However, if you run the business as S-corporation, the good news is the business income is NOT subject to employment taxes!
For example, if you have business income of $100,000 before paying yourself, assume you pay yourself through W-2 of $60,000, you are then leaving $40,000 as business income.
The w-2 income is subject to both income tax and employment tax, no difference when comparing to sole proprietorship.
The good news is the business income of $40,000 is not subject to employment tax so the tax saving could be about $4,800 every year!
You are smart so that you may ask why bother to pay $60,000 to yourself through W-2, isn’t it creating more tax saving if you allocate $100,000 to business income and the employment tax saving would have been $12,000. This is too good to be true. IRS disallows such arrangement.
The rule is any form of distribution to a S-Corp owner must be treated as payroll to the extent of a reasonable wage.
You may wonder what reasonable wage mean. Is $1 enough? Probably not.
The reasonable of wage depends on a few factors:
Do you make your income from your work (including managing work) ? Or from other employees ? Or from capital / equipment?
If you make your income mostly from your work/ services, you should conduct research to get the fair market value of the salary for such work. The rule of thumb is to pay yourself at market rate, sometimes it could be justified to pay a little less than market rate if you determine your operation is less profitable than other businesses in your local area.
Based on my experience, it is easy to trigger audit if you do not pay yourself through payroll from your s-Corp because the form 1120S requires you to disclose the salary to officer separately, on top of regular salaries to other employees. It is very easy to be on IRS’ spotlight when you are distributing money without paying yourself a reasonable compensation.
Click the link below from IRS website to understand more: