How to Save Taxes with an S Corporation

If you're a business owner or entrepreneur, you want to have a good understanding of how S corporations save small business owners tax. Accordingly, the paragraphs that follow describe the big benefit of an S corporation (which is that an S corporation minimizes employment taxes). But the paragraphs also describe some of the other, more subtle benefits of S corporation status.

First, however, a quick clarification: An S corporation isn't really a corporation. Rather, an S corporation is a corporation or a limited liability company that's made a Subchapter S election.

People (tax accountants included) call these entities that have made the election "S corporations." But in a sense, we should call them "Subchapter S corporations" when the entity making the election is really a corporation and "Subchapter S LLCs" when the entity making the election is really a limited liability company.

But enough on that. You want to know about the how Subchapter S saves business owners money.

The Big Subchapter S Tax Loophole in a Nutshell

Here is the big and principal S corporation tax loophole: An S corporation election allows a business owner to avoid Social Security, Medicare or self-employment taxes on a portion of the business profits. That's the deal. That's the trick.

And this tax avoidance gambit, which is regularly debated by Congress and then reaffirmed, works very simply.

To make the math easy, assume you have a small business that makes $100,000 a year in profits.

In this case, as you know, you pay income taxes to the federal government and, probably, to your state government too. How much income tax you pay to the federal government depends on a bunch of stuff. But as a guess, you may owe the IRS about $10,000 if your situation looks "average."

And then of course if you live in a state with income tax (and most people do) you probably pay another income tax to the state. Again, that tax depends on a bunch of stuff on your tax return--and then also the state where you live. But as a rough guess, you might pay say, $5,000, to your state government.

You also have another tax or set of taxes you pay on earned income, however: If you operate your business as a sole proprietorship or partnership, you will pay roughly 15.3% in self-employment taxes on your $100,000 of profits. The calculations get a little tricky if you want to be really super-precise but you can think about self-employment tax as roughly a 15% tax. So 15% on $100,000 equals $15,000. Roughly.

And a quick tangential point: If you happen to operate your business as a regular corporation and you extract the $100,000 of as shareholder-wages, the math in the end works the same way but tax law calls the taxes "Social Security" and "Medicare" taxes. Nevertheless, in this case you also pay roughly the 15% tax on the $100,000.

Okay. Now you're ready to understand how the Subchapter S election saves money. With an S corporation, you split your business profits into two categories: "shareholder wages" and "distributive share." Only the "shareholder wages" get subjected to the 15.3% tax. The leftover "distributive share" is not subject to 15.3% tax.

For example, suppose you split your $100,000 of business profit into $40,000 of wages you pay yourself for a job well done and then you call the rest of the money, the leftover profit, a "distributive share."

In this case, only the $40,000 of wages is subject to the 15.3% tax. So that means (roughly) a $6,000 Social Security and Medicare tax expense.

But the remaining $60,000 of business profit--the non-wages amount that accountants call "distributive share"--is not subject to the 15.3% tax. That means you're saving about $9,000 in self-employment taxes as compared to a sole proprietor or partner. Or that you're saving about $9,000 as compared to a guy that operates his or her business as a corporation and extracts all the business profit as wages.

Tax accountants get a little sheepish here. But this ability to avoid Social Security and Medicare taxes or self-employment taxes is the big benefit of an S corporation.

Note: S corporations also allow active shareholders to avoid the 3.8% Medicare surtax created by the Affordable Care Act (Obamacare) on business profits.

A Smaller S Corporation Loophole: Deductible Losses

As was just mentioned, the giant tax saving loophole associated with S corporations flows from the way S corporations let shareholder-employees avoid employment taxes. That's the big thing you want to focus on when you think about making a Subchapter S election for a corporation or LLC.

But two smaller general tax benefits associated with an S corporation should be mentioned. The first such benefit is this: If an S corporation losses money, that loss typically becomes a tax deduction on the shareholder's individual tax return.

For example, if you and your buddy each own half of an S corporation and the S corporation loses $10,000 for the year, you probably each get to add a $5,000 deduction to your individual tax returns. That deduction might save you anywhere from a few hundred to a few thousand dollars on your individual tax return.

By the way, there are some rules you have to follow to deduct these sorts of losses. In a nutshell, the money that's being "lost" needs to be your money. And you need to working in the S corporation. But again, this can be a neat little benefit for new businesses experiencing losses as they ramp up.

Another Small S Corp Benefit: Lower Audit Risk

Another minor tax savings benefit also flows from Subchapter S status: Probably an S corporation is a safer tax return to put tax deductions on. And that means you may be more comfortable claiming legitimate deductions.

No CPA is going to spend a bunch of time talking about this. You get the point.

A Final, Special Case Benefit: No Corporation Income Tax

One other tax savings benefit that S corporations deliver should be mentioned. This is a special case and applies only to businesses currently operated as regular corporations, also known as C corporations.

An S corporation (in most situations) pays no corporation income tax. And this feature means that as compared to a C corporation, an S corporation can save corporation income taxes.

For example, suppose a regular C corporation (after paying wages to shareholder employees) delivers pretax profits of $1,000,000. The corporation will pay a 34% corporate income tax on this money.

And then let's take it one step further: If the corporation distributes the leftover $660,000 to shareholders, the shareholders will pay another income tax. Most taxpayers by the way will pay a 15% tax rate on this money, so that would another $99,000 in income taxes and about $561,000 in leftover after tax profit.

But some taxpayers (those hit by the 3.8% Obamacare surtax and the latest rounds of "millionaire" tax hikes) pay a 23.8% tax on the $660,000. So that's roughly $157,000 in taxes and about $503,000 in leftover after tax profit.

Probably a regular corporation paying a 50%-ish tax rate should elect to be treated as an S corporation. As an S corporation, no corporation income tax would be levied. And when the income gets allocated to individual shareholders active in the business, they will probably pay a maximum rate of 40%. So that would mean around $400,000 in income taxes and then about $600,000 in leftover after tax profit.

Downloading a DIY Do-it-yourself S Corporation Kit?

If you're thinking about setting up an S corporation, you should know that you don't have to work with a local attorney or one of those popular online incorporation services.

You can instead do the set-up work yourself--it'll probably take about 30 minutes or so--by filling out three, relatively simple forms. And to make the process event easier, we actually provide economical downloadable kits for all fifty states. Click here to get to the page that tells you how to get one of our inexpensive do-it-yourself kits.

Can we make one other comment related to the idea of you setting up an S corporation? You probably want to use a CPA for your tax return preparation once you set up a corporation. The corporate tax return forms are more complicated and require a bit of specialized accounting to do right.

For what it's worth, our recommendation is that you find and work with a good local accountant who specializes in S corporations. Know, though, that if you can't find a good local CPA firm we would be delighted to provide this service to you and your business. (By the way, we're located in Washington state, so if you're in Washington state, especially if you're in the Seattle area, you ought to seriously consider using our firm...

More Ways to Save for Your Small Businesses

Can we plug a product or two that you may be interested in if you're here reading about how S corporation's save you taxes? We've written three short ebooks that you may find truly useful if you're considering the S corporation option as a tax reduction maneuver. In each of the books, we describe a different tax-planning technique that can save your business thousands of dollars a year in taxes. By the way, we offer a money back guarantee on these titles. If you buy one and don't feel like you get great value for your money, we will refund your purchase price without hassle or delay.

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