Making an S corporation election for your small business might save you a lot on taxes. But how does it actually work, and is it right for you? In order to explain the tax-saving under S corporation tax treatment, we first have to introduce the concept of self-employment tax.
Self-Employment Tax
Self-employment tax applies to your net earnings from self-employment. This could be earnings from your business establishment or contractor work.
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The self-employment tax rate is 15.3%. This consists of 12.4% for social security and 2.9% for Medicare taxes. You pay Social Security tax only until your earned income reaches $132,900 (effective January 1, 2019). This basically means you won’t pay more than $16,480 in Social Security taxes. You pay Medicare tax on all your earned income. Plus, there is an additional 0.9% Medicare tax on wages that exceed $250,000 if you are married-filing-jointly filers.
If your business is set up to be a pass-through entity, like a sole proprietorship or partnership, you must pay self-employment tax on all of your business net earnings. Imagine your share of the net profit from an LLC-partnership is $50,000. When the profit passes through the business and you report it on your personal 1040, the entire $50,000 is subject to the 15.3% self-employment tax. However, you do get an above-the-line adjustment for approximately half of the self-employment tax you paid. This reduces your adjusted gross income (AGI) and your personal income tax liability.
How S Corporation Helps Reduce Tax Liability?
Under S corporation tax treatment, the IRS requires that you pay yourself a reasonable salary. “Reasonable” usually means 40% – 60% of your annual business net profit. You also have to run payroll for yourself as long as your business is profitable. When you do this, you no longer have to pay self-employment tax on your business’s total net profit. You only have to pay self-employment tax on the salary you pay yourself. The IRS taxes the remainder at your corresponding personal income tax rate.
Is S Corporation the Right Choice for You?
Business owners first need to double check if they are even eligible to make an S corporation election. S corporations can’t have more than 100 shareholders. Shareholders may only be individuals, certain trusts, estates and certain exempt organizations (such as a 501(c)(3) nonprofits). Shareholders may not be partnerships or corporations. If they are individual shareholders, then they have to be US citizens or tax residents.
Even though an S corporation election does help save self-employment tax for most profitable business owners, it might not be beneficial if your business is just slightly profitable or if your business can’t maintain its profitability in future years. Since you are required to issue yourself a regular paycheck and track withholdings, you will incur the additional payroll expense every single year just to stay in compliance. Thus, you have to consider if your savings from making S corporation election will surpass the additional payroll expense. You do have the option to revoke S corporation election, but you will have to wait 5 years to make an S corporation election again for the same entity.
Claiming Deductions
Claiming a home office deduction also works a bit differently under S corporation tax treatment. Now that you are an employee of your own S corporation business, you certainly can’t deduct the home office expense as a miscellaneous itemized deduction on your 1040 Schedule A. This was disallowed by the 2017 Tax Cuts and Jobs Act (TCJA). In order to still claim the deduction, your business has to have an accountable plan in place to reimburse employees for their home office expense. The business will then report the cost on the business return and on your personal 1040, and you will report rental income and corresponding expense.
Whether an S corporation election makes sense to you largely depends on your business profit projection and business location. NYC for instance, charges additional 8.85% GCT tax on NY state S corporations. Your personal tax situation can also make a difference. The assistance of an experienced tax accountant can certainly help to smooth the road and make sure you don’t encounter any surprises.
