Should I elect S Corporation status?
Many small business can save on taxes when operating as an S Corporation. My general rule of thumb is if you can pay yourself a reasonable salary from you company, and still have $20,000 of profits left to take as a distribution, an S corporation can save taxes for you
Can I do this with my LLC or corporation?
How can I avoid self-employment tax and save money?
S corporations can pay out some of their profits as a distribution. Distributions are not subject to self-employment tax.
A sole proprietor pays self-employment tax of 15.3% (Social Security and Medicare) on all profits. With an S corporation, the corporation will pay 7.65% (Social Security and Medicare) and the employee will pay 7.65% (Social Security and Medicare) on all wages. This means that the effective Social Security and Medicare tax total is the same in both cases: 15.3%.
However, an S corporation need not pay all of its profits to its employee(s) as wages. Some earnings can be withheld and paid to the shareholder(s) as a distribution.
To illustrate this, consider the following example:
You earn $100,000 after expenses.
Sole proprietor: 15.3% is paid as self-employment tax: $15,300.
S corporation: The employee is paid a reasonable salary of $70,000 for the year. Note that the salary must be reasonable; it could be higher or lower depending on circumstances.) The S corporation will withhold $5,355 and the employee will pay $5,355 in taxes. This means a total of $10,710 total is paid in taxes. The remaining $30,000 can be given to the shareholder (who is the same person as the employee) as a distribution; this would not be subject to self-employment taxes (Social Security or Medicare).
So the sole proprietor pays $15,300, while the S corporation pays $10,710, a difference of $4,290.
This example considers at a situation in which $30,000 is distributed. When deciding whether you will save, remember that the amount distributed determines the savings.
Other costs to consder
California S corporations pay $800 or 1.5% of their income, whichever is higher. Further, there are costs associated with the tax filings for the corporation, the cost of payroll, and the cost of maintaining the corporation.
When determining if an S corporation will save money I start with these costs, and I start high.
I use $800 for the tax. In California all profits of an S corporation are taxed at 1.5% or $800, whichever is greater. (This means that if you have $53,333 or less in profits, then you pay $800. If you make $53,334 or more, then you are taxed at 1.5%, in which the S corporation is almost surely saving you money.)
I plan on $1000 for accounting costs, and $500 for payroll. I budget $500 for legal fees associated with maintaining the corporation.
All told, that means the cost of the S corporation is $2800. (This is a high number.) Working backwards, in order to save $2800, you need a distribution of $18,300.
This brings us back to my rule of thumb: If you can pay yourself a reasonable salary from your company and still have $20,000 in profits left to take as a distribution, an S corporation can result in lower taxes for you.