If you're self-employed, one way to help avoid higher Social Security and Medicare taxes is to organize your business as an S-corporation.
Key Takeaways
- Self-employed individuals typically pay higher Social Security and Medicare taxes than if they were employees of a company.
- Organizing a business as an S-corporation can help you avoid higher self-employment taxes by classifying some income as salary and some as a distribution. That way, you will only owe self-employment taxes on the salary portion.
- The IRS may scrutinize S-corps returns to ensure a "reasonable" amount of income is designated as wages, not distribution.
- While S-corps may save on self-employment taxes, they can have additional start-up costs and ongoing legal and accounting fees. Also, some states require S-corps to pay additional fees and taxes.
S-Corp taxes
If you're self-employed, you'll usually have to pay higher Social Security and Medicare taxes, collectively known as self-employment taxes, than if you were an employee of a company. One way to help avoid these higher taxes is to organize your business as an S-corporation. The Internal Revenue Service may take a close look at your taxes if you choose this route, as you could end up lowering your overall tax liability while generating the same net income.
Self-employment taxes
Whether you're self-employed or an employee, you'll have to pay Social Security and Medicare taxes to the government. When you work for someone else, you're only responsible for part of these taxes, while your employer pays the balance. However, if you're self-employed, you have to pay both portions of this tax. The combined employee and employer portions of this tax amount normally amounts to 15.3 percent.
TurboTax Tip:
Trying to avoid too much self-employment tax could trigger an IRS inquiry.
S-Corp distributions
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation.
Risks of S-Corporations
The IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $500,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a "reasonable" amount of your income as wages, rather than a distribution. What constitutes "reasonable" can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.
Additional costs for S-Corporations
While an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors.
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FAQs
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion.
How can an S Corp reduce taxable income? ›
Business Deductions: Every dollar your S-corp spends on legitimate business expenses can reduce your taxable income. This includes: Vehicle Expenses: If your vehicle is used for business, expenses like gas, repairs, and insurance are deductible. Only the business use portion is deductible.
How do I lower my self-employment tax? ›
- Form an S Corporation.
- Subtract Half of Your FICA Taxes From Federal Income Taxes.
- Deduct Valid Business Expenses.
- Deduct Health Insurance Costs.
- Defer Income to Avoid Higher Tax Brackets.
If you re-form your business as an S corporation, set your annual salary to $100,000 and pay out the remaining $700,000 as a distribution, the S corporation option saves you approximately $28,000 each year in employment taxes.
What is the 60 40 rule for S Corp? ›
Under this strategy, the owner would pay themself 60% of earnings as a salary and the other 40% as distributions. [1] That percent split is applied regardless of the company's earnings, which makes it easy and often advised by accountants and other sources, but also problematic.
How does S Corp avoid self-employment tax? ›
Creating an S Corporation can potentially reduce self-employment taxes by allowing business owners to split their income into salary and distributions.
Can you leave money in an S Corp and not pay taxes? ›
At the end of each year, all S corporation profits are allocated to the corporation's shareholders. Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits.
What is the 2% rule for S Corp? ›
Under these S corp income tax rules, a greater than 2% shareholder is taxed as a partner in a partnership for fringe benefits received. The Internal Revenue Code (IRC) establishes that officers, who also are shareholders, are considered employees for employment tax.
At what income is S Corp worth it? ›
Examples of S Corp tax savings
The more money you pay yourself as a distribution, the more Social Security and Medicare tax you'll save when you run an S Corp. Likewise, the more profit your business earns, the more you'll save. You need to earn at least $40,000 in profit for an S Corp to make sense, though.
What is the reasonable salary for a S Corp? ›
What is the 60/40 rule? The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
S Corps that lose their “S” status must typically wait five years before being able to re-elect it. As mentioned, deliberately violating one of the rules, such as transferring stock to an ineligible shareholder, is not a good thing.
How often do S Corps get audited? ›
Truth be told, most S-Corp audit concerns stem from net profits being paid out as distributions without corresponding salaries, and the associated Social Security and Medicare taxes. To reiterate, only 0.42% of S-Corps were audited, and of those examinations, a whopping 62% resulted in no change.
What two forms of income can an owner of an S corp take? ›
An S Corp owner has to receive what the IRS deems a “reasonable salary” — basically, a paycheck comparable to what other employers would pay for similar services. If there's additional profit in the business, you can take those as distributions, which come with a lower tax bill.
How do corporations reduce taxable income? ›
How do profitable corporations get away with paying no U.S. income tax? Their most lucrative (and perfectly legal) tax avoidance strategies include accelerated depreciation, the offshoring of profits, generous deductions for appreciated employee stock options, and tax credits.
How can taxable income be reduced? ›
8 ways to potentially lower your taxes
- Plan throughout the year for taxes.
- Contribute to your retirement accounts.
- Contribute to your HSA.
- If you're older than 70.5 years, consider a QCD.
- If you're itemizing, maximize deductions.
- Look for opportunities to leverage available tax credits.
- Consider tax-loss harvesting.
From hiring family members to implementing HSAs, there are several simple ways that may help you save on taxes.
- Hire Family Members. ...
- Account for Business Losses. ...
- Track Your Travel Expenses. ...
- Consider All Expenses Such as Rent and Utilities. ...
- Hire a Reputable CPA. ...
- Deduct Assets to Charity. ...
- Track Every Receipt With Software.
Maybe. The loss could be limited to Basis limits, At Risk limits or Passive limits. But if none of those apply to your specific loss, then yes, after the corporation prepares its own tax return, the loss would flow to your personal tax return and offset other income.
