S-CORP TAX SAVINGS
Under the right set of facts, operating an S-Corp can save you thousands of dollars each year. The savings come from reducing the amount of income you receive that is subject to payroll taxes. However, there are important guidelines that must be followed to protect against a challenge from the IRS. Before we get into the guidelines, please read the next section for a basic breakdown of how the savings arise.
HOW THE SAVINGS ARISE
Right now, if you are self-employed or an independent contractor, all of your net earnings (from Schedule C) are subject to the Self-Employment Contribution Act (SECA) payroll taxes. SECA consists of two parts – OASDI (12.4%) and Medicare (2.9%). Therefore, you are solely responsible for paying a flat tax of 15.3% on every dollar earned. Keep in mind this is in addition to your Federal Income Tax liability.
Now, if you operate as an S-Corp, you can pay yourself “reasonable compensation” which will be subject to payroll taxes. However, anything over the salary you pay yourself is not subject to payroll taxes. Therefore, you can save 15.3% on the difference between what your net earnings were and the compensation you pay yourself.
Here is a simplified example:
In 2015 you had net earnings of $100,000. Based on that, you will owe $15,300 in payroll taxes. If you were an S-Corp in 2015 and paid yourself a reasonable salary of $50,000, your payroll liability would have been approximately $7,650. The remaining $50,000 can be distributed to you from the S-Corp without being subject to any payroll taxation. In other words, you would pay half the amount of payroll taxes as an S-Corp in the above situation.
Please remember, the illustration above is simplified to give you a general idea of how the savings arise. However, there are several other factors to consider (reasonable compensation, additional costs, state business taxes, other taxes). At Spaulding Legal, APC we have developed a comparison tool that will identify whether the tax savings are enough to justify forming an S-Corp. Simply click here to gain access to the tool. If you have any questions about how to use the tool or would like additional information, please do not hesitate to contact us.
ANALYZING ADDITIONAL FACTORS
The analysis of whether to form an S-Corp does not stop at the payroll tax savings. In fact, before you can accurately calculate what your payroll tax savings are you must first determine what “reasonable compensation” is. The general rule for determining reasonable compensation is to look at what a third party would make if they took your position. The analysis is fact specific and should rely on multiple sources to help protect against an IRS challenge. At Spaulding Legal, APC we take the time to assist you in determining what your reasonable compensation should be. Our goal is to minimize your tax liability while staying with the boundaries of the law.