Exploring how business owners save tax dollars when converting their business to an S corporation. 

 

S corporations have long been recognized for their ability to save LLCs money on taxes. Is this true? It depends. In this article, we’ll walk through the benefits of S corps and how this structure can help business owners save money on their taxes. 

What is an S corp?

Before we get into saving money let’s start with the basics: An S corp isn’t a legal business entity—it’s a method of taxation, and any qualifying business can elect to be taxed as an S corp. To become an S corp (shorthand for S corporation), your business must be an existing LLC or Corporation. 

 

How S corps save people money

No corporate income tax

Businesses that elect to be taxed as an S corp don’t pay corporate income tax. Instead, they pass their income directly to business owners who then report profits and losses on their personal tax returns. Since S corps don’t pay corporate income tax, the only official “tax rate” of an S corp is whatever amount the business owner’s personal income level corresponds with on the tax bracket. 

 

No double taxation

Double taxation refers to the two instances in which a regular C corporation is taxed: Once when the corporation pays income taxes and again when corporation owners pay taxes on dividends they receive. Since S corps don’t pay corporate income tax, they avoid being taxed twice. 

 

No self-employment tax on earnings

Shareholders can divide earnings into separate salary and profit portions. The salary portion is still subject to self-employment tax (Medicare and Social Security), but the profit portion is subject only to regular income tax. Depending on how you divide your salary and profit, you may save a substantial amount by converting to an S corp. Generally, an employer pays half of your portion of Medicare and Social Security, but as a self-employed individual, you are required to pay the entire portion. As an S corp, you only pay those taxes on your salary portion, not the entire earnings of the company. 

 

Since the majority of self-employment tax phases out at $142,800, the real tax savings potential of S-corp owners occurs because they are exempt from paying self-employment taxes on the income between their reasonable market salary and $142,800. 

 

Note: Because of this taxation structure, some S-corp shareholders are tempted to pay themselves an artificially low salary in order to avoid excess self-employment tax. However, the IRS frowns heavily upon this strategy. When electing to be taxed as an S-corp, pay yourself a reasonable market salary for your position and responsibilities. 

 

Example of Tax Savings

Here's a simplistic example of how this might work in practice. Let’s say your business earned a net income of $100,000 in 2020, and you pay yourself a $75,000 salary. The extra $25,000 is funneled back into the business. As a sole proprietor, you would pay self-employment tax on the full net income of $100,000 ($100,000 x 15.3% = $15,300). If you elected to be taxed as an S corp, you would only pay self-employment tax on the $75,000 in salary ($75,000 x 15.3% = $11,475), resulting in a savings of $3,825. Note that the self-employment taxes are only paid on the salary portion of earnings, not the entire profits of your company. This is where S corps have the power to save thousands of dollars. 

 

Overall, the decision to be taxed as an S corp should be made with a trusted financial advisor. It’s important to look at company needs, state restrictions, and additional management restrictions associated with S corps. Regardless, taking the time to research this potential change could save you significant tax dollars in coming years.