Thirty years ago when I first started my business I didn’t even think about forming a corporation. The paperwork seemed daunting, the internet barely had any useful information on how to do it and the price to incorporate was a bit steep for a new company that hadn’t even billed for its first job yet. So of course by default I was a Sole Proprietor.
And that suited me just fine. I was running networking cable through ceilings, installing network cards in x386 PCs and working hard to get offices connected to the new modern world. I did the work, invoiced the customer and didn’t think at all about business taxes.
And what a dry topic that is! Can you believe there are people that actually dream about that stuff? Like in a good way? It takes all kinds to make up this big world.
Anyway it wasn’t until I started to do well and accumulate some personal possessions (house, car, etc…) that I started thinking about liability and my lack of protection. Maybe that’s why liability is most often mentioned as the #1 reason to incorporate? It was definitely the reason that triggered me to make the change.
I didn’t even consider an LLC at the time since that business model was either brand new or non-existent in California. Instead I made the drive to downtown Sacramento and gathered up the paperwork I needed in the Secretary of State’s office. I filled it out, paid my fees and waited for my corporation acceptance to arrive in the mail.
Fast-forward to a year later and it was tax time again. I had paid myself a decent salary and the remainder of company profits filtered down to me as a disbursement from my S-Corporation. I was quite surprised when I ended up paying less taxes than the previous year despite a slight growth in the business. Could I really have made more money and saved more money too?
Absolutely. As I mentioned before in my company structure article in the section on taxes, an S-Corp, and any company taxed like an S-Corp (such as an LLC that has elected this), can avoid both business taxes and a portion of payroll taxes. This adds up to significant savings.
Avoiding the corporate taxes is simple: as an S-Corporation there is no double taxation on income. Done. Fini. Any business profit filters down to your personal taxes on a Schedule K-1 instead of being taxed at the corporate rate and then being taxed again when you get it.
Table of Contents
Explaining Self-Employment Taxes
How is getting the money on a K-1 different from a Sole Proprietor? Self-employment taxes.
Your SP income comes down to you on a Schedule C form and is subject to self-employment taxes while a Schedule K-1 is not. Remember self-employment taxes are to be avoided if possible and here’s why: as of 2020 they are 15.3% of the net income amount so for every $1,000 you pay $153 to the government – with a few other caveats.
Get the picture?
|Schedule C Net Income
The IRS loves it when you stay a Sole Proprietor. All that extra Social Security and Medicare goes right into the government coffers instead of your pocket. Ok sure you could argue that you might get to use that money someday when you retire, provided you live that long, but you sure aren’t going to use it now.
Self-employment taxes are a combination of the Social Security and Medicare taxes (12.4% and 2.9% in 2020) which equal that 15.3%, but luckily there is another rule on Social Security taxes called the “wage base limit” that caps the SS taxes over a certain amount. In 2020 that’s $142,800 which means that you are only taxed on SS on income up to $142,800. Amounts above that are only subject to the Medicare rate.
Because of the wage base limit on SS the table doesn’t look quite so bad as the numbers get higher:
|Schedule C Net Income
|Social Security Tax
(12.4% on first $142,800)
|Total Self-Employment Taxes
“But John that’s still bad!” Yes it is. But having the wage base limit for SS means only $32,207 in taxes at a $500,000 income instead of $76,500.
Avoiding Self-Employment Taxes
“But I don’t even want to pay $32k! Can I avoid paying all those taxes by just converting to an S-Corp?” Well yes – but no. The IRS is very aware of this desire and has some rules and guidelines in place to make sure that everyone is paying their fair share into the SS and Medicare systems.
According to the IRS code every officer of a corporation is also an employee and you are not allowed to avoid SS and Medicare by disbursing profits to an officer without paying a salary to that officer. Furthermore, the rules of the 1120S tax form state, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
That means that you can’t get away with declaring all your income as a disbursement instead of payroll and avoid paying any SS or Medicare. You have to pay yourself a reasonable salary.
A Reasonable Salary
What is a reasonable salary? I’ve talked to a few accountants about this and from what I can gather the easiest way to figure this out is to ask yourself what you would pay someone else to do what you do for the company. You’re the CEO so what does a CEO of a company your size get paid? When you’re first starting out that may be 100% of your profits, but as those profits climb that percentage becomes less and less. I’ve heard other accountants say that your salary doesn’t need to exceed 60% of your total compensation. Others say 40%. Whatever you decide to use I would run it by your accountant first to make sure you’re following a guideline that won’t get you red-flagged by the IRS.
My primary job for my company is as a software developer, so for me it’s simple to see what others in my industry get paid, then I tack on a bit for the management I need to do and call that my salary. I have two close friends who each own separate music schools and carry a full load of students themselves. I would think it would be fairly simple to see what other full-time teachers are making and then tack on some management figure, like an extra $500-1000 a month, and call that your salary. The rest you take as a disbursement and save on your tax.
Disclaimer: My salary advice has thus far worked for me, but I cannot guarantee that it will keep you out of trouble. I am NOT your accountant. I am not an accountant at all. If you need one please go get one.
Payroll is Deductible
Ok it’s a bummer that you have to pay yourself a salary, but there’s a silver lining to that too: all payroll expenses are deductible and will lower your taxable income.
|Payroll Expenses on $1000/wk. Gross in California
|Employee Income Tax
|Employee Social Security
|CA State Income Tax
|CA Disability Insurance Tax
|Employer Social Security
Notice the gross payroll amount of $1000 actually costs the employer $1,076.50. That extra $76.50 is the employer half of SS and Medicare (6.2% + 1.45% = 7.65%). If you’re a Sole Proprietor you’re paying these on your entire income with the self-employment tax, but as an S-Corp you only pay them on the payroll portion of your income. And while only a little less than half of self-employment taxes are deductible, all payroll expenses are deductible.
This is key so I’m going to repeat it: If you’re a Sole Proprietor you are paying the equivalent of payroll taxes on your entire income with only half of it being deductible.
That means that an S-Corp with a profit of $10,000 before payroll who then wrote out the payroll check above would have a taxable income of only $8,923.50 (10,000 – 1,076.50). Lowering your taxable income lowers your income taxes.
Lowering your taxable income lowers your income taxes.
How Much Can I Really Save?
Just by incorporating into an S-Corp we’ve got a few things going for us:
- No corporate taxes, avoiding double taxation
- No self-employment taxes
- Only a portion of your income is counted as payroll with subsequent payroll taxes
- All payroll taxes are deductible which lowers your taxable income
Lowering your taxable income can even put you in a lower tax bracket which can lower your taxes even more. So how much money does your business need to make where it’s worth it to incorporate your business?
It gets a little too complicated for back-of-the-envelope accounting for me so I took the time to run a few sets of numbers through the popular Intuit® TurboTax® suite of applications. For these tables I used an SP with the level of income indicated as consulting income and no expenses, and an S-Corp with the same level of consulting income but with $1,000 in expenses just to cover the cost of having a corporation. For the S-Corp I chose to pay half of the business income in payroll and disburse the other half. In a real world case you would probably be paying yourself much less in payroll as the income rises which would make the savings even greater.
Bear with me here – I know looking at tables of numbers can be tedious. Just scan down the right hand column to see how much you can save at the increasing income levels by being an S-Corp instead of an SP:
|Sole Proprietor Taxes
Considering it costs about $1,000/year just to maintain the corporation you still come out ahead by over $3,500 at $50,000 in income. The question then becomes, “is it worth $3,500 to have to do all the corporate paperwork and reporting?” The short answer for me is “YES!”
Incorporating is not that difficult and keeping up with the paperwork is not that involved. Don’t worry – I’ll show you how. Just remember that next time someone tells you that incorporating is only for liability protection you can tell them you did it to keep more money in your pocket.