So what is an S-Corp tax election and how can it save you money?
Everyone pays taxes. The typical taxes that an employee pays are (in no particular order):
- Federal, State and Local income taxes. These have different rates depending on how much you make. See note 1 for the current brackets.
- FUTA and SUTA-federal and state unemployment taxes. If you have employees, you are required to pay a percentage of their wages (anywhere from 0.9% to 11%) into a federal or state “fund”. If an employee files a claim for unemployment, he or she gets paid out of this fund.
- FICA-Federal Insurance Contributions Act. In other words, Medicare and Social Security. The current rates are 15.3% of your wages (12.4% for SS, 2.9% for Medicare). If you are an employee, your employer pays half of that (7.65%, and this is a deductible expense for the employer). The other 7.65% is withheld from your paycheck.
Now, if you are self-employed, you still pay the federal and state income taxes on your earned income as well as FICA. But here’s the rub-you pay the full 15.3%. So, you are paying more than an employee is. You do get to deduct one-half of this, 7.65%, from your adjusted gross income. This is meant to offset your additional load. This situation applies if you are a sole-proprietor, a partnership, even an LLC.
Now here’s how you (legally) get around this.
Step 1) Form an LLC. It doesn’t matter if it is a single-member or partnership, but you have to be an LLC. There is an initial $500 filing fee with the Commonwealth of Massachusetts and an annual $500 filing fee plus any fees you might pay to someone to help you form the LLC.
Step 2) Fill out and submit a form 2553 to the IRS. This is a one-time procedure where you “elect” to be treated as an S-Corp in the eyes of the IRS. There are no fees for this election.
So what does this mean? When you elect S-Corp status, you treat yourself, the owner, as an employee and pay yourself reasonable wages. Reasonable means an average pay for someone in your industry. Any difference between what you pay yourself and your total net profits is “distributed” to you as a dividend that may be tax free or taxed at a lower rate.
Let’s use this example. Two companies, one a sole proprietor called John and the other an LLC called Jane who has elected S-Corp tax status. Both companies had net profits in 2014 of $60,000 ($5,000/month). This is after paying all business expenses, but before any other deductions or credits. John pays self-employment taxes on all $60,000 of his income. Jane allocates herself a reasonable income for her trade of $48,000 per year ($4,000/month or $25/hr).
John’s self employment taxes for the year:
Jane’s self-employment taxes on her earned income for the year:
So right away Jane has saved $1,836 in taxes. Remember though, this is not all the taxes you will pay as a self-employed business person. You still have to pay federal and state income tax. This works out the same for both the sole-proprietor and the S-Corp.
Federal taxable income = Net income - 1/2 of the self-employment taxes
=$60,000 - ($9,180/2)
=$60,000 - $4,590
=$55,410 x 25% (tax bracket for $60,000)
=$13,852 federal income tax
Another way to calculate the federal taxable income:
=Net income x 92.35%
=$60,000 x .9235
=$55,410
State taxable income = All of the net income. You cannot deduct the self-employment taxes in Massachusetts
=$60,000 x 5.15%
=$3,090
The tally so far:
But what about the $12,000 that Jane didn’t pay herself? The excess money is distributed to the share holds (Jane) as a dividend. Once a month, Jane writes a check to herself for $1,000 and writes the word “dividend” on it. Since you only pay self-employment taxes on earned income, this dividend, can, but not always, be tax free. See the next blog entry for a discussion on the taxability of dividends.
The new tally after factoring in dividends and filing fees:
There is more paperwork involved in becoming and maintaining an LLC and S-Corp, but $13,336 is a fairly good profit.
Footnotes:
Note 1-Federal Income Tax Brackets