Tax Advantages of S Corporation

The tax advantages of an S Corporation vs sole proprietorship or partnership is typically in the Self Employment tax. With a sole proprietorship or general partnership, all profits are in one bucket that flows out to the owner for taxation. The owner is taxed for income tax and self employment tax. Income tax depends on the owners individual tax bracket and self employment tax is 15.3% on top of the income tax up to the FICA maximum threshold.

With an S Corporation, the owner’s income from the business is put into two buckets, wages and business profits. Both are subject to income tax on the owner’s individual tax return, just like the profits from a sole proprietor or partnership.

The wages are paid like any other employee so the business pays 7.65% FICA/Medicare tax and the owner/employee has 7.65% FICA/Medicare tax withheld from his or her pay. 7.65 plus 7.65 is the same 15.3% you pay in self employment tax.

However, the business profits are only subject to income tax and not self employment or FICA/Medicare tax.

So let’s say your business has $100,000 profit. In a typical 20% tax bracket that income from a sole proprietorship/partnership is taxed 20% of $100K plus 15.3% of $100K or $35,300. That same $100K profit in an S Corp works like this: Say $50K of reasonable compensation leaving $50K of business profits after owner’s salary.

Income tax is $50K of wages plus $50K of profits at 20% or $20,000. Employment tax paid by the business 7.65% of $50K $3,825 plus 7.65% of $50K FICA/Medicare withheld from wages another $3,825. Total tax bill under the S Corp is $20,000 plus $3,825 plus $3,825 or $27,680. $7,620 less than you would pay in a sole proprietorship.

There are some lesser benefits such as how the owner might be able to have the business pay for individual health insurance. There are also some compliance issues such as filing quarterly payroll returns and issuing W2’s. The wages are also subject to unemployment tax, which is typically a small incremental cost if any. There is also the issue of determining “reasonable compensation”, as there are no bright line rules about what is reasonable, so I highly recommend that if you are considering an S Corp, you should first have a conversation with a US tax professional so you understand all the compliance issues you face.

I will not recommend S Corp for clients who operate the business out of their hip pocket. If you want to take advantage of the tax savings available in an S Corp, then you need to be willing to act like a real grown up business first.

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