Saving Taxes with S Corporations

C Corporations pay tax based on their income. The first $50,000 of income is taxed at 15%. The next $25,000 is taxed at 25%. The last $25,000 is taxed at 34%. Thus, the total corporate income tax on $100,000 of income is $22,250. This leaves $77,250. However, the money is still in the corporate bank account. To get the money to the owner, there will be additional tax.

The owner can take these funds through dividends or through wages. If the owner takes the funds through dividends, he pays a dividend tax of 15%. Although this is a good tax rate, it is the second time this income is taxed. He will pay $11,588 dividend tax and be left with $65,662 to buy groceries.

For someone in a 35% tax bracket, this is a pretty good result. The problem is that this person worked for his company and did not pay himself/herself a reasonable wage. The IRS has the power in this situation to re-label the $100,000 dividend as wage. In that case, the corporation would owe employment taxes, penalties and interest.

The owner could pay the corporate profits out to himself/herself. In that case, the corporation must pay 7.65 percent ($7,106) employment taxes (social security and medicare). The owner will have the same amount of employment taxes withheld from his/her paycheck. The gross paycheck will be $92,894 ($100,000 minus the corporation's employment tax).

The business owner will have to pay individual income tax on his gross paycheck. The income tax will be $32,513 (35% of paycheck). This will leave the business owner with $53,275 to spend on groceries or other personal expenses. This example shows the additional impact of employment taxes (15.3% between the employer and employee).

If the business was a sole proprietor instead, there would be only one level of income tax and the owner would not need to pay a wage. However, the net business income would be subject to income tax (35% in this example) and self employment tax (15.3%). Accordingly, this business owner would pay income tax of $32,527 and self employment tax of $14,130. (The figures are not $35,000 and $15,300 because one half of the self-employment tax is deductible.) After paying income tax and self employment tax, the business owner is left with $53,343 to buy personal items. The result would be the same if the business were a single member LLC or if the owner had a partnership interest with $100,000 of business income. Sole proprietorship, LLC and partnership profits are all subject to self employment taxes. Just like the employment tax in the previous example, self employment tax has a dramatic effect on your after tax income.

Unlike a C Corporation, an S Corporation is a flow through. This means it doesn't pay income tax. Rather the income flows through to the S Corporation owners and the owners pay tax on this income at their marginal tax rate (35% in our example). Unlike sole proprietors, LLCs and partnerships, S Corporation profits are not subject to self employment tax.

The owner pays only income tax of $35,000 leaving income after tax of $65,000. The owner pays tax on the profits of the corporation but does not pay a dividend tax when the funds are transferred to the owner.

This would be fine if this was just an investment and the owner was not working in the business. When an owner works for an S Corporation, the IRS requires the corporation to pay the owner a "reasonable wage". If the owner in this example worked for the S Corporation, the owner would have greater risk of an audit by the IRS. The IRS would argue that the entire distribution is actually wage. The corporation could be subject to employment taxes on this wage, interest and penalties.

In this example, the S Corporation owner pays himself a wage of $20,000. This is probably very aggressive but significantly better than no wage. In certain circumstances, it could be supported as reasonable. For example, the profits could come largely from the efforts of employees or capital and the owner's effort could be minimal. In this example, the corporation pays employment taxes of $1,530 on the owner's wage.

The owner will have the same amount (i.e. $1,530) of employment taxes (i.e. social security and medicare) withheld from his/her paycheck. The owner will pay income tax on the $20,000 wage and the remaining $78,470 of S Corporation profit. The income tax total is $34,465 leaving the owner with $62,475 after tax to spend on personal expenses.

Note that you can achieve the same results if you have an LLC that elects to be taxed as an S Corporation. LLCs can elect their tax treatment with the IRS. If no election is made, single member LLCs are treated as sole proprietorships and multiple member LLCs are treated as partnerships.

While this taxpayer's income tax burden is high (i.e. 35%), the owner was able to achieve significant savings over other entity forms like a sole proprietorship or LLC (without an election).

We made a number of assumptions in order to easily present this information. People often ask, "what is the best form of entity organization?" The answer is different for every business. There are a number of differences between the tax effect of different entities that we cannot cover here. Just for example, a home office deduction is allowed against sole proprietorship or LLC income but not against S Corporation income. Also, cost basis is calculated differently in S Corporations versus LLCs. It's possible that a large loss from an S Corporation would be suspended (i.e. not currently deductible) when such a loss would be deductible in an LLC under the same fact pattern! In the examples presented above, the business owner lowered the self employment tax and achieved significant tax savings with an S Corporation. To determine what is best for your small business, consult your CPA or tax accountant.

CPA John Huddleston has a law degree and masters in tax law from the University of Washington School of Law. He has been a guest tax expert on the radio. He advises small businesses in the Seattle Bellevue Tacoma and Everett area on various tax issues. His firm, Huddleston Tax Accountants, also provides tax preparation service, quickbooks training and setup and general accounting and bookkeeping service. Profile information on John Huddleston and the CPAs employed by Huddleston Tax Accountants is available at CPA Tax Accountant Profile. Seattle Bellevue tax CPA John Huddleston is a frequent publisher of tax saving ideas.

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