Can an S corporation save me money?

With the economy in the doldrums, many folks are starting businesses to bring in a little side money.  If you decide this is for you, there are a few important steps to take in forming your new venture.

I’ve written before about the importance of forming a limited liability company (LLC) to protect your personal assets.  Today, I’d like to discuss the advantages (and disadvantages) of forming an S corporation.

Self-employment tax

Whenever you earn money not as an employee, you owe self-employment tax, in addition to income tax. It doesn’t matter whether you’ve formally incorporated, filed as an LLC, or are just going door-to-door peddling homemade soap; it’s income, and you need to pay Uncle Sam his share.  The self-employment tax is 15.3% of income (revenue less expenses), which is a hefty bite.  Unlike income tax, the self-employment tax rate is fixed — not progressive — the smallest street vendor pays the same rate as a high-end attorney.

Self-employment tax pays for Social Security (12.4% — up to the first $106,800 (2009)) and Medicare (2.9% — no income limit). If you are an employee, you and your employer each pay half of this amount; as a self-employed person, you get to pay it all.

The advantage of an S corporation:  Pay less self-employment tax

To reduce your self-employment tax bill, you can create an S corporation and hire yourself as an employee.  You pay the employee (you) a reasonable wage for the work done.  If there is profit left over at the end of the year, the partners (that’s you again) split the earnings. Self-employment tax is only paid on wages — not on the company profit.

An example:  Pat and Alex run similar web-design businesses.  Pat organized his business as a sole proprietor, and Alex organized his as an S corporation.  At the end of the year, they each made $50,000, after expenses.  As a sole proprietor, Pat will pay 15.3% of the entire $50,000, or $7,650 in self-employment tax.  Alex researched other web-design firms and found that it was reasonable to assess a $40,000 wage for the work that he did that year.  Alex will pay 15.3% on $40,000, or $6120, saving himself $1,530.

So far, sounds good.  What’s the hitch?

The disadvantages of an S corporation

You have to decide what is a “reasonable wage.”  The IRS doesn’t define it any further than that.  Obviously, you don’t want to pay yourself only $1.  Uncle would call that tax evasion — not avoidance.  You need to do a little research to back up the value used for your assessment.  If you can document it, you should be able to pass an audit.  Another approach I heard tossed around was to make a 60%/40% split (60% of earnings taxed as wage), but I didn’t find any substantiation for that number.  It’s probably better to do your homework and determine a reasonable wage.

You are now an employee.  Hopefully you’ll get along with the boss.

You are now an employer.  You must now file taxes for your employee, and you must withhold employee earnings for taxes and submit these to the proper revenue authorities.  You must now pay federal unemployment tax (FUTA) (6.2% of the first $7,000 in earnings), which you do not have to pay as a sole proprietor.  The FUTA tax reduces Alex’s tax advantage from $1,530 to $1,096.  Depending on state regulations, you may also be required to pay state unemployment and disability insurance, too.  You must generate a W-2 for your employee, too.  The additional paperwork is sufficient hassle that some folks end up hiring a payroll contractor, similar to ADP or Paychex, or more likely, your local small-business accountant.  If you’re the DIY type, QuickBooks can help you track payroll transactions.

You must form a corporation.  The paperwork is a bit more complicated than for an LLC.  It varies by state, but the Articles of Incorporation can be sufficiently complex that you’ll need to see an attorney to understand if you’re really doing the right thing.  The Articles of Incorporation for an LLC are usually quite straightforward.

You may have to deal with other state requirements.  For example, Massachusetts now requires all employers to provide health insurance to employees.  Many self-employed persons rely on their spouse’s health insurance.  So even if you’re covered by your spouse’s policy (fulfilling the requirements for the Massachusetts Form 1 Schedule HC), you may need to file additional paperwork with the state to demonstrate that all of your employees have health care coverage.

How to create an S corporation

You create an S corporation by first creating a corporation (technically, a C corporation).  You then notify the IRS that you want to have your corporation taxed under the S corporation rules by filing Form 2553: Election by a Small-Business Corporation.  This form must be filed by March 15th; otherwise, you have to wait until the next year.

How to file taxes as an S coporation

S corporations, like partnerships, are separate entities and require their own tax return.  (Sole-proprietorships are pass-throughs, and the income is reported on the owner’s 1040 Schedule C or C-EZ).  The tax form is 1120S:  US Income Tax for an S Corporation, and it is due on March 15th (A month earlier than our usual deadline — just to keep you on your toes).  On your 1040, your wages are reported on line 7, and the business income is reported on line 17.

Spreadsheet example

I put together a spreadsheet comparing Pat’s and Alex’s taxes in Excel and pdf form.  In the Excel version, you can modify the revenue, expenses, and tax rates to test your own situation.  I added a few other considerations, such as the fact that a sole proprietor can deduct one-half of the self-employment tax.  Please have a look at the details, if you’re interested.

The bottom line:  Is an S corporation right for me?

Answer:  It depends.  Your business situation is unique.  You should seek advice from your accountant, attorney, or other financial professional.  The S corporation option is preferred (relative to a sole proprietorship) when the business is relatively large — the greater the income, the more you’ll save by forming an S corporation; therefore, the more likely it’s worth the additional paperwork.

Image credit: Jerine at Flickr.

This post was an Editor’s Pick at the 76th edition of the Money Hacks Carnival hosted by Pinyo at Moolanomy.

Tags: business formation, S corporation, self-employment tax