Your CPA is likely well-meaning, and he or she is generally knowledgeable about taxes. But they’re trained to make sure you’re in compliance with the tax code after the fact. Proactive tax planning isn’t their strong suit. But when you look at the tax year ahead, you need a strategy before you get to the end of it.
For example, if you operate your business as a sole proprietorship, has your CPA warned you about the self-employment tax? If you operate your business as a sole proprietorship, you could actually end up paying more in self-employment tax as you do in income tax.
If that’s the case, you might want to think about setting up an S corporation to reduce that tax.
How an S-Corp Can Assist with Self-Employment Tax
If you’re taxed as a sole proprietor, you’ll report your net income on Schedule C. You’ll pay tax at whatever your personal rate is. But you’ll also pay self-employment tax of 15.3% on net self-employment income up to the Social Security wage base ($128,400 for 2018) and 2.9% of anything above that.
Let’s say your profit at the end of the year is $80,000. You’ll pay regular tax at your regular rate, whatever that is. You’ll also pay about $11,000 in self-employment tax. That self-employment tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed.
If you’re like most readers, you’re not planning to retire on that Social Security. You’ll be delighted if it’s all still there, but you’re not actually counting on it in any meaningful way. What if there was a way you could take part of that Social Security contribution and invest it yourself? Do you think you could earn more on your money yourself than you can if it’s sitting with the Social Security Administration? Well, there’s a way you can, and it’s called an S corporation.
An “S corp” is a corporation that doesn’t pay tax on its profits, and can also pay you a salary for the work you do via those profits. If there’s any profit left over, it passes the profit through to your personal return, and you pay the tax on that income on your own return. The S corporation splits your income into two parts, wages and pass-through distribution.
Here’s why the S corporation is so attractive. You’ll pay the same 15.3% employment tax on your wages as you would on your self-employment income. But, there’s no Social Security or self-employment tax due on the dividend pass-through. And that makes a world of difference.
Let’s say your S corporation earns the same $80,000 as your proprietorship. If you pay yourself $40,000 in wages, you’ll pay about $6,120 in Social Security. But you’ll avoid employment tax on the income distribution. And that saves you $5,184 in employment tax you would have paid without the S-corporation.
The best part here is that you just pay less tax all throughout the year. It’s not like buying equipment at the end of the year to get big depreciation deductions. You have to spend money on the equipment to get that depreciation.
It’s also not like contributing money to a retirement plan to get deductions. That may be another great strategy, but it also means you must take money out of your budget to contribute to the plan.
Be Aware of Potential Pitfalls to S-Corps
To make this work, you must pay yourself a “reasonable salary” for the service you provide as an employee. In other words, pay yourself the salary you would have to pay to hire an employee to do the work for you. If you pay yourself nothing or a token amount, the IRS can consider all your income as wages and hit you with some very hefty taxes, interest, and penalties. So don’t get greedy! We can help you determine the right amount to pay yourself to “color inside the lines.”
One guideline: according to IRS data, the average S corporation pays out about 40% of its income in the form of salary and 60% in the form of distributions. So, you can see that there’s at least a possibility for real savings for yourself.
Request a Free Tax Assessment with Financial Gravity
This solution is one among many available to you when you work with one of Financial Gravity’s team members. If you are a small business owner and you’re tired of paying too much in taxes, Let’s Talk!