Toward the end of each year, unincorporated businesses begin considering tax structure advantages to implement in the following year. One of these is obtaining S corporation status. When your annual profit reaches approximately $50,000, you may want to consider this option as a way to save on taxes.
If you do decide to convert your business into an S corporation next year, you’ll need to know that a great deal of planning is involved. The issue of converting to an S corporation is surrounded by multiple guidelines from the tax authorities, but no solid formula. Your accountant can help you navigate this labyrinth of guidelines and assist you in deciding whether the option is a good one for you and your business.
How it saves
Figuring out how converting to an S corporation can reduce a tax burden begins with understanding how proprietorship operations in the United States are taxed. Profit is subjected to two distinct taxes – regular income tax and self-employment tax. The latter is reported and paid on your annual income tax return, but it’s calculated separately from ordinary income tax.
Self-employment tax is a flat rate assessment on profit; it comprises contributions to the owner’s Social Security and Medicare accounts. Corporations – as distinct entities from their owners – do not pay self-employment tax.
How do you get paid?
Unfortunately, incorporated small businesses are confronted with the confusing problem of having to forward corporate profits to their owner(s). This is confusing because receiving a salary from a corporation you own doesn’t reduce your tax burden. Why? Because this salary incurs the Social Security and Medicare taxes you’re trying to avoid.
Compensation via dividends is even worse. Dividends do not represent an income tax deduction for a corporation. As a result, corporate income remitted to an owner as dividends is considered taxable income for both the corporation and the individual.
Special S corporation status eliminates this double taxation. Profit simply passes through to an owner for calculation on his or her individual income tax. No self-employment tax is assessed because the owner is receiving taxable profits as a shareholder.
More complexities arise when the shareholder is the working operator of the enterprise in addition to owning the business. Tax rules do not allow this person to receive all of the compensation as a shareholder’s taxable profits. Enjoying the tax savings from operating an S corporation – in which you’re both the shareholder and officer – is only allowed when you receive reasonable compensation for your operational services. That means receiving some compensation as wages, which then incurs Social Security and Medicare taxes. But the remaining corporate profit after the cost of your compensation does escape these employment taxes.
Identifying compensation that satisfies the requirement for reasonableness presents a challenge to anyone serving in the dual role of S corporation shareholder and officer. But it’s not insurmountable. As mentioned previously, discuss this in your annual pretax meeting with your accountant, and he or she will ensure you’re in compliance.