As anyone who has ever decided to start a business can tell you, paying taxes is one of the biggest challenges and drawbacks of being in business for yourself.
If you’re self-employed, you have to pay an extra share of self-employment taxes (the payroll taxes that pay for Medicare, Social Security, unemployment benefits and other ongoing government programs).
If you’re an employee, these taxes get withdrawn from your paycheck and you might not notice how much you’re paying. But even as an employee, payroll taxes add up to about 7.5% of your income (up to $90,000 – any income over that amount is taxed at a lower rate for payroll tax purposes).
When you start a business and become your own employer, if you’re paying taxes as a sole proprietor, you have to pay TWICE as much payroll tax as you used to pay as an employee – both the 7.5% employee share and the 7.5% employer share. This means that about 15% of your business income is going to payroll taxes.
Is there any way to pay less in payroll taxes? Or is every business owner stuck with paying this much higher amount of self-employment tax?
One way to reduce your self-employment tax liability is to incorporate a business as an S-Corporation. The tax advantages of an S-Corporation are one of the biggest reasons why this choice of business structure has become one of the most popular ways for small businesses to incorporate.
What are the biggest S-Corporation tax advantages?
- Pass-through taxation: An S-Corporation is not a tax-paying entity. Just as when you decide to form an LLC, by incorporating as an S-Corporation you are saying to the IRS that the company will not pay any taxes; instead the company’s income will “pass through” to the company owners/shareholders, who will be required to report that income on their individual tax returns.
- No corporate income tax: Unlike a C-Corporation, an S-Corporation does not owe any corporate income tax. All of the company’s earnings are passed through to the shareholders based on the percentage of each shareholder’s ownership of the company.
- Reduction in self-employment tax liability: If you are a sole proprietor or owner of an LLC, you have to pay the double-share of self-employment taxes because in the eyes of the IRS, you are both the “employee” and the “employer.” Incorporating a business as an S-Corporation gives you the ability to re-classify your status: instead of being treated like an “employer,” with an S-Corporation you only have to pay taxes as an “employee.” Instead of paying double-self-employment taxes, the S-Corporation allows your company to pay you a salary (and you’re required to pay self-employment tax on that salary amount), and also give you a “distribution” of company earnings that are free from self-employment taxes. This can add up to thousands of dollars in tax savings, depending on your income and tax bracket.
NOTE: CorpNet does not give tax advice and this article does not claim to do so. Please consult with a professional tax adviser before making any final decisions about whether to incorporate as an S-Corporation (or other corporate entity) and how to handle your corporate and personal income tax responsibilities.