An S Corporation Could Cut Your Self-Employment Tax
- Find out how you could save on your taxes with an S corporation.
- Learn the fundamentals of self-employment tax.
- Find out what consequences you may face if your S corporation doesn’t pay you “reasonable” compensation.
- How do you determine “reasonable” compensation?
- Discover the complications in converting from a C corporation?
If you’ve organized your business as a sole proprietorship or as a wholly owned limited liability company (LLC), you’re subject to both income tax and self-employment tax. But, you may have a way to cut your tax bill by conducting business as an S corporation. Keep reading for some tips from Fiducial!
Fundamentals of self-employment tax
The government imposes the self-employment tax on 92.35% of self-employment income at a 12.4% rate for Social Security up to a certain maximum ($142,800 for 2021) and at a 2.9% rate for Medicare. No maximum tax limit applies to the Medicare tax. They impose an additional 0.9% Medicare tax on income exceeding $250,000 for married couples ($125,000 for married persons filing separately). In all other cases, this amount is $200,000.
But, what if you conduct your business as a partnership in which you’re a general partner? In that case, in addition to income tax, you’re subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation, you’ll be subject to income tax. However, self-employment tax will not apply to your share of the S corporation’s income.
An S corporation isn’t subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss, and deduction pass through to the shareholders. However, the income passed through to the shareholder isn’t treated as self-employment income. Thus, by using an S corporation, you may avoid self-employment income tax.
An S corporation requires “reasonable” compensation
Be aware that the IRS requires that the S corporation pay you reasonable compensation for your services to the business. They treat the compensation as wages subject to employment tax (split evenly between the corporation and the employee). This is equivalent to the self-employment tax. If the S corporation doesn’t pay you reasonable compensation for your services, the IRS may treat a portion of the S corporation’s distributions to you as wages. Then, they will impose Social Security taxes on the amount it considers wages.
There’s no simple formula regarding “reasonable compensation.” Presumably, reasonable compensation is the amount that unrelated employers would pay for comparable services under similar circumstances. Many things factor into making this determination.
Converting to an S corporation
There may be complications if you convert a C corporation to an S corporation. A “built-in gains tax” may apply when you dispose of appreciated assets held by the C corporation at the time of the conversion. However, there may be ways to minimize its impact.
Many factors to consider
Would you like to discuss the factors involved in conducting your business as an S corporation, and how much the business should pay you as compensation? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.
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