How to Save Thousands in Taxes With an S Corporation

Consider Forming an S Corporation for Payroll Tax Savings

Consider forming an S corporation if you are a business owner looking to minimize your tax bill and receive additional liability protection.

January 6, 2022

It’s a well-documented fact that over 70% of businesses in the USA comprise sole proprietorships. This means that they are a single-owner enterprise, with the owner functioning independently. Sole proprietorships cover a wide gamut of sectors – from advertising, catering, and tutoring to event planning, wellness professionals, and photography. 

The upside of working independently is the flexibility, autonomy, and ownership of one’s time that come with it. However, on the flipside there is a huge tax liability that one must factor in when looking at profits versus revenues.

Tax Rules for Sole Proprietorships 

A sole proprietor’s income is taxed 100%, to cover benefits such as Medicare and social security. Since the founder is both the employee and the owner, they end up paying both personal tax as well as business tax on all earnings. 

They must also pay taxes on all the profits earned. One unique approach to offsetting being doubly taxed is to register one’s business as an S Corporation. This is a tried and tested approach that helps small businesses save thousands of dollars every year. 

Shifting to S Corporation entity

The S Corporation is a legally-recognized business entity that can be availed by small businesses with 100 or fewer shareholders. It must be for profit. When a small business registers as an S corp business entity, it is exempt from paying federal taxes. 

Owners can take home a salary from the profits; on this amount, they are taxed as employees. The remaining profit is then distributed to the owner/s as dividends on which you pay capital gains tax, which is still lower than taxes levied on businesses. 

How much can you really save? 

Say your estimated net income for the year is $150,000. Say you convert your business entity to S Corp status and pay yourself a salary of $60,000. As a sole proprietor, you would have been taxed on the full $150,000, thus paying an annual self-employment tax, which amounts to $20,196.

However, on conversion to S Corp status, you would only be paying self-employment taxes on $60,000, which amounts to $9,180, i.e., generating a savings of $11,016. There are no self-employment taxes on the remaining profit of $90,000; the income tax you pay on this amount depends on how dividends are taxed in your industry and state. 

How much should you pay yourself? 

The Internal Revenue Services (IRS) prescribes certain industry standards as a guideline for how much you must pay yourself. Something too high or too low could attract unnecessary scrutiny by the IRS. If they detect any red flags, your business may then be considered for an audit. Follow the guidelines set by your IRS to arrive at the best figure. 

When to make the shift to S-Corp 

You are in luck; the right time to make the shift from a sole proprietorship to S Corp is at the start of a new year, i.e., January 1st, and not the financial year. The reasons for shifting at the start of the year are very logical. By doing so at this time, you will need to maintain just a file for the financial dealings of your business throughout the year.

However, if you make the shift at any other time of the year, you will need to maintain two files – one as a sole proprietorship and one as an S Corp. You will also be filing taxes in two different modes, which could result in further chaos and confusion. This can also result in errors in the long term. 

Should you make the shift?

The S Corp status isn’t necessarily a good step for every small business looking to save on taxes. It is important for your business to reach a certain benchmark of profit so that it makes legal sense to make the shift. One key indicator that your business is S Corp ready is that it has a steady cash flow. This is important as your business must be able to afford the additional costs that come with making this entity shift. 

For instance, an S-corp business will need to pay parking expenses for those shareholders or employees owning at least 2% of the stock. However, unlike a C Corp, this expense head does not reduce the taxable income for shareholders or employees. While Medicare and social security are covered, additional expenses such as group life insurance do not come with any tax benefits for an S Corp. 

Hence, making the shift is a strategic decision and must be carefully considered.  

Access professional advice

The decision to shift to S Corp is not a simple one, and you need to take several considerations into account. For instance, the readiness of the business, eligibility, the timing as well as ensuring it is done in the right way. As a business owner, you aren’t always equipped to evaluate and do the transition by yourself.

You’d rather focus on delivering your business outcomes on priority. Instead, you can look at leveraging the services of a professional to help with this aspect of the business. 

With the right support, the transition can be a seamless process. Outsourcing the entire process could be a worthy investment in ensuring the long-term sustainability of your business.

Choose the right partner 

It’s important that you partner with a firm that has a proven record of advising businesses and helping them transition based on their real-time needs.

Try and evaluate whether their expertise is up-to-the-mark and that they are savvy about the latest developments. They must also be savvy about tax rules as they apply to different states. Taxation laws keep changing, and the wrong advice can cost your firm thousands of dollars. On the other hand, investing with the right partner can save your firm thousands of dollars.

Transparency, accountability, and efficiency are other requirements. For instance, if your business is not yet in the best position to transition to an S-Corp status, your advisor must be transparent and suggest the best way forward. Look for references from successful businesses in your network of friends and peers. 

Do your research well, and pick the right partner.