The Perils and Pitfalls of S Corporations
I am sure you will all agree with me when I say that deciding which type of entity structure is best for your business can be a confusing and frustrating experience. There are various types of business structures out there where certain entities save you money in taxes, while other types of entities cost you more money in taxes. To make things worse, even if you have the right "type" of business entity set up, the question becomes: Are you using that entity correctly to actually help you save taxes?
This week, we want to go more in depth into one of the most commonly used business structures for small to mid-sized business owners, and that is the S Corporation. Let's go over some of the strategies relating to S Corporations as well as some of the most common and costly mistakes we often see when it comes to correctly using your S Corporation.
An S Corporation provides the same limited liability to its owners as a C Corporation does, meaning that owners typically are not personally responsible for business debt and liabilities. Similar to partnerships and limited liability companies, S Corporations have pass-through taxation, which means that the Corporation itself generally does not pay taxes at the corporate level. The net income of the S Corporation is passed through to the shareholders of the company and reported on their individual income tax returns. The S Corporation is a popular choice for business owners because it offers the liability protection of a Corporation but avoids double-taxation.
Here is where the plot thickens. Although the S Corporation may sound like a simple business structure on the outside, here is the biggest opportunity (and mistake) that owners of S corporations make:
In addition to avoiding double-taxation, S Corporations are usually established to save money by minimizing the 15.3 percent self-employment tax (a.k.a. "SE tax" or "payroll tax") of its owners. The way to minimize payroll tax is with a strategy known as the salary/dividend split. Salary paid to an owner-employee of an S Corporation is treated like wages paid to any other employee. The amount of money that the owner takes out as payroll is subject to payroll taxes just as if the owner were operating the business as a Partnership, LLC, or Sole Proprietor.
Most of you are probably thinking, "Wait ... I thought you said I can save on payroll taxes with an S Corporation? Sounds like I still have to pay that anyway?" Before you get too discouraged, here is where it gets good. The business owner can also take profits out of the S Corporation as distributions each year. The money that is taken out as distributions is generally not subject to payroll taxes.
If you are staying ahead of this strategy, your next question is probably "Why don't I stop paying myself via payroll and take all of my money out as distributions and pay zero taxes?" This is where many owners of S Corporations get themselves into trouble. They try to avoid the self-employment tax altogether by taking only distributions and not paying themselves a reasonable salary. This is a clever strategy except that it will not fly with the IRS.
In fact, if you have a profitable business in an S Corporation where you are an employee who is not paying yourself payroll, the IRS will disallow your strategy altogether and determine that 100 percent of the company's profits must be subject to federal income taxes, state income taxes, and payroll taxes. No one works for free. As an owner-employee of an S Corporation, the IRS expects you to receive wages for services rendered to the company. That's why owners must pay themselves a reasonable salary if the business is profitable.
The goal is to keep that salary as low as possible to pay less payroll taxes. For example, if your company makes $50,000 in net profits and you structure yourself correctly with an S corporation to pay yourself a salary of $20,000, you can save close to $4,700 per year in payroll taxes.
On the flip side, another common mistake S Corporation owners make is paying too high of a salary to themselves that it diminishes the company's tax-saving strategy completely. It shouldn't be too high of a high salary and it shouldn't be too low either, but it must be a "reasonable amount." A reasonable salary is defined as the amount that you would pay someone else to do your job. Factors to consider would include market rates for the type of work performed, geographic region, comparisons with similar companies, and amount of hours worked, just to name a few.
To give you an idea of how much money you can save, let's look at an example: Julie Johnson is the sole owner of JJ Home Designs, an S Corporation, with a projected net profit of $100,000. She enjoys the finer things in life and wants to pay herself a very high salary to cover all of her personal expenses. She decides to pay herself a yearly salary of $100,000. With that salary, she has to pay $15,300 in self-employment taxes. But if Julie instead paid herself a "reasonable salary" of $30,000 a year, then she only has to pay $4,590 in self-employment taxes.
By reducing her salary to the reasonable amount, she would save $10,700 in self-employment taxes. The greatest thing about this strategy is that this is a permanent tax savings of $10,700 and it is a savings that she will get year after year as long as the company's payroll is done correctly. Wouldn't you like to increase your cash flow by $10,700 each year?
