If you’ve been in business for a while, you’ve probably heard something about the tax advantages of operating as an S corporation. At the same time, you might not know what specific tax advantages S-Corp status provides. So today, we’re going to take a brief look at S-Corps and some of the important ways they can help your business.
You may have heard me say before that US tax law can be extremely beneficial for business owners of all sizes—not just large corporations. And S-Corp election is a great example of this, because operating your small or medium-sized business as a S-Corporation can be a big tax savings winner.
Brief History of the S-Corp
Way back in 1958, the US Congress created the S-Corporation to give small businesses the legal protections of a big “C” corporation while reducing the federal employment tax burden on small business owners. By design, the benefits of operating as an S-Corp are part legal, and part financial.
Later, in the late 1970s, the state of Wyoming created the first Limited Liability Company (LLC), which slowly rose in popularity throughout all the states in the US. The big benefit of the LLC was that it gave businesses strong legal protection without all the legal and procedural requirements of a corporation. (On the other hand, LLCs do not do anything to reduce the employment tax burden for business owners.) And this is why S-Corps are a big deal—because they reduce federal employment taxes owed.
How S-Corps can reduce taxes
Here’s a simplified example of how filing as an S-Corp could reduce a business’ tax burden:
- A small business owner (operating as a sole proprietor, partnership, or LLC) is required to pay federal employment tax on all business profits.
- This small business owner decides to start operating his business as an S-Corp. And after this transition, the business owner pays himself a reasonable salary (which is subject to federal employment tax) and then makes further cash distributions to himself (which are not subject to the employment tax!).
- So the business owner’s tax bill is significantly reduced! Because now, only the business owner’s salary is subject to the federal employment tax.
Of course, this simplified example doesn’t account for things like state tax laws, what the IRS’ criteria are for what constitutes a “reasonable” salary, and legal and accounting procedures that business owners will need to implement. But it still shows how businesses that start operating as an S-Corp can theoretically save money on taxes.
But how much money could operating as a S-Corp actually save me?
Let’s find out by adding some numbers to our hypothetical example:
- A small business owner (whether that be a sole proprietor, partnership, or LLC) is required to pay federal employment tax on all business profits. Let’s say the small business makes $146k/yr in profit in 2022. Our business owner would pay $22,491 in federal employment taxes based on 2022’s rates (note that this doesn’t include state taxes or federal income tax).
- So this small business owner decides to start operating his business as an S-Corp. And after this transition, the business owner pays himself a reasonable salary (which is subject to federal employment tax) and then makes further cash distributions to himself (which are not subject to the employment tax!). Let’s assume a hypothetical reasonable salary for this business owner would be $60,000 (what’s reasonable according to the IRS would be based on precedent and comparable salaries within the same industry). That means the business owner would be taking cash distributions of $86,000 that aren’t subject to federal employment tax.
- So the business owner’s tax bill is significantly reduced! Because now, only the business owner’s salary is subject to the federal employment tax. In our example, the hypothetical business owner will now pay $9,180 in federal employment tax, which is $13,311 less in employment taxes IN ONE YEAR. And assuming your situation stays the same, you could get the same tax benefit EVERY YEAR going forward.
Additional S-Corp benefits
Up to this point, we’ve only been talking about reducing employment tax (which is important because it’s relevant to all business owners). But additionally, once your business is taxed as an S-Corp, you will be able to use specific tax strategies that were not an option for you as an LLC. Implementing these tax strategies can result in tax deductions that could save you tens of thousands of dollars every year. Most of these specific S-Corp tax strategies will require you to be more active in managing both your business’ cash flow and financial paperwork—so they’re not for everyone. But if you’re willing to put in the work, one or more of these strategies might be a good option for you. Do any of the following apply to you?
- You want to maximize your retirement contributions
- You need to pay for continuing education (MBA or professional certification)
- You’re interested in having the business pay your family’s health insurance premiums directly
- You’re interested in having your business reimburse you for your family’s out-of-pocket medical expenses
- You would like to hire your spouse as an employee (or one of your underage children as a part-time employee)
- You’re interested in renting your home to your business completely tax-free to you personal
These are just some of the many situations where you could potentially benefit from S-Corp tax strategies. If this is something that interests you, keep reading…
So, should I be operating as a S-Corp?
If you’re intrigued and wondering if you should be operating your small business as an S-Corp, I suggest you ask yourself the following six questions:
- Are you a small business owner? (Currently operating as a sole proprietor, LLC, partnership, or LLC Partnership?)
- Is your business making at least $80,000 per year?
- Are you a United States citizen?
- Are you forward-thinking and committed to making your business successful?
- Are you willing to comply with some increased payroll and legal requirements in exchange for substantial tax savings?
- Do you (or your household) have other taxable income streams in addition to this business?
If you answered “Yes” to most of the questions listed above, you should learn more about operating your business as an S-Corp. Recently, I launched a new service called the S-Corp Transformation Service, which helps you file the required S-Corp election paperwork and also addresses all the legal and financial elements that go along with it (payroll setup, accounting procedures, tax strategy, ongoing support, etc.).
Over To You…
Are you operating your business as a S-Corp? If not, what’s holding you back?