Tax policy makers in the US have helped small business with the S Corporation election option, which may reduce your self employment tax liability. Here’s what you need to know.
Warning. The content here is offered as a general guide only. The information presented here is general in nature any may not apply to your situation. Misinterpretation of the tax code and s corporation taxes could result in IRS adjustments which may lead to more tax being owed, penalties, and interest. We insist that you must seek professional legal and accounting help for your s corporation and business needs.
Self Employment Tax for Small Business
As you are probably aware, a self employed individual is subject to both income tax and self employment tax. The self employment tax is for social security and medicare taxes that are not otherwise being collected from wages.
This is somewhat unfair if you are a small business owner who draws a normal salary from your business and then you make more profit as a result of your risk/success model. Some of your income will be generated from invested time and capital. This portion of your income has more of the “investment” characteristic to it – more so than a “wage” characteristic.
For example, let’s say that you sell widgets online, and you become very successful, making a net profit of $100,000 every year. A reasonable salary for someone who manages the business might be $60,000 – but you have to pay self employment tax on the entire $100,000. This does not account for all of the other “hats’ that you wear as the owner or all of the capital you invested. After all, you are not just an employee.
Fortunately there is tax policy that allows the successful self employed to have their cake and eat it too, with some restrictions.
The S Corporation Election for your Small Business
The S-Corp election allows a qualifying business entity to treat their business as a corporation, but have the income flow through to the shareholders rather than being taxed at the corporate rate and then again at the individual level (double tax).
Corporate income is treated as ordinary income to the shareholders, and is not subject to self employment tax.
Requirements for the S-corp Election
Here is a simple summary of who qualifies to be taxed under sub-chapter S. Please get advice from a professional before organizing your business as such.
The company has to be a US domestic corporation or other qualifying domestic entity (an LLC for example).
The company also must have 100 shareholders or less.
The shareholders themselves must be individuals, estates, certain exempt organizations, or certain trusts.
All of the shareholders of an S-Corporation must be US citizens or resident aliens.
The company can only have one class of stock.
The company cannot be most bank, thrift, or insurance chapter L companies – and a few other non qualifiers.
There are also tax year requirements to s-corp qualification, and each shareholder must give their consent.
Organizing a Business for the S-Corp Election
If you decide that setting up an S-corp is the best solution for your business, you must go through a legal process to organize the entity, and then make a timely s-corp election with the IRS.
Entity organization can be filed through a lawyer’s office or online paralegal service.
Once the articles on incorporation are filed you must submit the election to the IRS within a certain time frame.
Self Employment Taxes and the S Corporation Election
Once you have an s-corporation set up you must pay yourself a reasonable salary for the services that you provide and count the rest as ordinary income. The advantage of this is that you only pay self employment tax on the salary, and not the corporate profits. You still have to pay income tax on the corporate profits, of course, but not having to pay self employment taxes on this portion of the profit can save you thousands per year.
Some common pitfalls of this strategy is not setting up the payroll properly. When you pay yourself you have to withhold taxes and pay them to the treasure within certain deadlines. Missing these deadlines or making errors can cost you big in penalties.
Caution! Another mistake is to under-estimate how much your labor is worth. If the IRS deems it as unreasonable, and you have been unlawfully circumventing self employment tax for a few years, you could end up facing a huge tax bill. The IRS is likely to go back several years and hit you with some nasty penalties and taxes that have piled up.
S-Corp Taxation May Not be Appropriate for Your Business
If you have a small business that is not yet making much of a profit, then it may not be appropriate to elect s corp taxation quite yet. The self employment tax savings only started to exceed the additional expenses of the payroll and income tax returns at about a net profit of $40,000 or so.
Periodically your accountant must make payroll installments to the treasury, along with the appropriate informational payroll returns.
Many states charge a flat franchise tax to each entity as well – along with requiring annual reports.
You also have to pay any state sales or excise taxes as required – but this is true whether you have elected s corporation taxation or not.
At the end of the year you must file the year-end payroll reports to the IRS and any employees (including yourself).
Every year, your accountant must file IRS form 1120s about a month before the normal tax deadline and issue form K1 to the shareholders. Penalties for not filing on time start at $190 per month per shareholder!
Of course you must also file your individual taxes by the normal deadline as well.
All of this sounds like a lot – but it can save you a substantial amount in self employment tax. If fact, most successful small business take advantage of the s corp election. We’re an s corp, for example, and we can make this very easy on you. We are very experienced with corporation taxation and we have a simple and affordable program that includes everything. The only difference you will notice is the tax savings.