Are you missing out on one of the best tax benefits available today?
If you are like most business owners, then you run your business as sole a proprietorship or a C Corporation. If so, you might want to check out becoming a Subchapter S corporation! There are many benefits, but I?m going to discuss one of the best, saving Self Employment (Social Security) taxes.
A sole proprietor must pay self employment taxes on all the income earned from the business. That?s 15.3% on your first $72,600 and 2.9% on all the rest of your income. On $100,000 earnings, that?s almost $12,000 in self employment taxes! I?m sure you?ll agree you can probably get a lot better return on that money if you invested it yourself. That is even assuming you will get any of this money when you retire. By then, the retirement age might be higher, pay out less, or you might be entirely ineligible for SS benefits because of your investment income (there?s been talk of using this as a qualifier to SS eligibility).
Instead, form a corporation and file for Subchapter S status with the IRS using Form 2553. There are, of course, restrictions. However most small businesses are eligible to do this. Let us use me as an example.
One of my first corporations was set up for my insurance business. It started out as a sole proprietorship. Then, my accountant told me about the benefits of a Sub S Corp. So, I formed The Banner Agency, Inc. and immediately filed for Sub S status with the IRS (you must do this by the 16th day of the third month of the forming of your corporation). Then I paid myself a salary (you must do this too). My accountant suggested I pay myself what it would cost to hire someone else to run my business in my place. Since my agency was young, I decided I could only pay myself $12,000 per year the first year. Although I realized this was small, and probably less than what I would hire someone for, I figured I was OK since my business was in its infancy and profits were not very predicable (the next year I paid myself $18,000). If you?ve been operating for a while and/or earning more money, you will want to pay yourself more.
After the first year, I had $12,000 in W2 income and my corporation earned another $25,000, for a total of $37,000. The approximately $2000+ per month in profits, I paid myself as an “owner dividend” each month. Social Security & Medicare taxes (as employer and employee) were due on the $12,000 W2 income. But, I saved the self employment taxes on the $25,000 as this was considered non earned dividend income. In other words, I saved almost $4000 ($25,000 X 15.3%) in taxes! The following year savings were even greater as my earnings were higher. The key here, is that all profits earned by your corporation are taxed as non earned income at your normal federal and state personal tax rates, but NOT by Social Security or Medicare!
What are the negatives? Besides the cost to set up your Sub S Corporation, there are the additional yearly filing expenses for a corporate tax return and annual report to your state. My accountant charges $500 per year for these services. When you do retire, assuming you are eligible, your retirement income (from Social Security) will be less, because you paid less into the system. However, this should be more than offset by the retirement windfall you will receive from all the tax savings you invested! Additionally, you could pay yourself more as you get close to retirement so as to increase your SS retirement benefits.
Run the numbers for your business and ask your accountant if this will work for you. Be aware however, your accountant may say this is not a good idea. He or she may not be aware of all the benefits. This happened to many friends of mine who had similar businesses but were told that there was little difference to their tax situation if they filed as a Sub S Corp. If you?re not getting an answer that sounds right, get a second opinion. Go to SmallBiZeMarket.com and quiry accountants for your area. We may have a name or two of a good accountant in your area who is well acquainted with the benefits of a Sub S election for your corporation.
So what are you going to do with all that extra money?