Tax Tip Tuesday
Why You May Want to Consider Making an S Election
No business type starts out as an S Corporation. You must request to be treated as an S corporation by filing an election with the IRS. Entities are allowed to file this election if they meet the following requirements:
- No more than 100 shareholders
- No nonresident aliens as shareholders
- No more than one class of stock
- No corporations or partnerships as shareholders
What is an S Corporation?
An S Corporation is typically a business formed by incorporating in a state as a corporation or filing articles of organization as a partnership and then elects to be an S Corporation for income tax purposes. Businesses typically make this election to avoid double taxation and instead have the income and losses pass through the business to its owners’.
How are S Corporations Taxed?
A key feature of S Corporations is their ability to minimize taxes for you and your business. Income that passes through is subject to tax on your personal tax return. Additionally, losses incurred may be made available to you and directly offset your personal income. However, that’s no different than an LLC treated like a partnership right! Well the major difference between tax treatment as a partnership versus an S Corporation is the treatment of the owners and how much of their income is subject to self employment tax.
Self Employment Tax Savings
Self employment taxes are comprised of two parts: Social Security and Medicare. You pay 6.2 percent and your employer is required to pay Social Security taxes of 6.2 percent as a match. You each also pay Medicare taxes of 1.45 percent on all your wages – no limit. If you are self-employed, your Social Security tax rate is 12.4 percent and your Medicare tax is 2.9 percent on those same amounts of earnings but you are able to deduct the employer portion.
For tax purposes, sole proprietors and partnership are not allowed to take a wage. Instead their total share of net income from operations is taxed at normal ordinary tax rates, plus an additional self-employment tax is tacked on at 15.3 percent (12.4 percent social security + 2.9 percent medicare tax mentioned above). However, an owner of an S Corporation is allowed to be an owner/employee and is actually encouraged to report wages to herself. Big deal right! Well this tax treatment allows the S Corporation owner to reduce their self-employment tax liability. The S Corporation owner will only pay the self-employment tax on their wages and not their entire share of S Corporation earnings for the year.
To illustrate, let’s compare the two structures to see how you can save money by making an S election by March 15th. In this illustration we’ll assume the business made $100K and the owner took a wage of $40K:
In this illustration the owner saved $8,000 by simply making the S election. Although their ordinary income tax increased, their self-employment tax was more than cut in half. This is because the S corporation self-employment taxes were limited to the $40K wages paid to the owner versus the self-employment taxes the partnership paid on the entire $100K of earnings.
To learn more about choosing the right entity type for your business book an appointment with one of our tax professionals today!