What You Need to Know About S-Corp and Self-Employment Tax

by Augustus Callen

Are you a business owner who would like to avoid paying self-employment tax? Here’s S-Corp and self employment tax: what you need to know. If so, consider converting your sole proprietorship or LLC to an S-Corp. The S-Corp eliminates self-employment tax by shifting half of the employer’s liability to the business. As a result, you will pay payroll taxes on the business’s net income instead of self-employment taxes on your employees.

S-Corp is a hybrid Between a Partnership and a Corporation

An S-Corp is a type of corporation. Its tax laws are similar to those of a partnership but allow the shareholder to elect to have his or her income and losses treated as distributions. As such, all business income, losses, and deductions flow through to the shareholder’s personal tax return. In addition, the shareholder’s wages must meet standards of “reasonable compensation,” which can differ by region or occupation.

An LLC is similar to a corporation but lacks the formalities of a corporation. As a result, LLCs do not have corporate bylaws that all shareholders must follow. However, they do have flexible operating agreements. For example, an LLC also does not need to record company meetings. Additionally, LLC members may choose who runs their business. For example, an LLC with its owners in management roles would operate like a partnership.

In most cases, an S-Corp will only have one class of stock, unlike a corporation. This means that the owners will not pay corporate income tax. Instead, the profits will pass through to the owners’ tax returns. However, one significant advantage of an S-Corp is that the owner is not taxed twice. Another benefit is that employees are treated as employees of the corporation, thus saving money on taxes.

Pays No Income Tax

There are some nuances to calculating your S-Corp salary. First, your salary should be pass-through. Divide it by the number of pay periods in the year to arrive at the total salary you should pay yourself. This will also determine your FICA, unemployment, and payroll taxes. Your shareholder-employees must file quarterly taxes to report income taxes and payroll taxes withheld. Finally, you may have to file Form 1040-ES, or estimated taxes, to note any additional income.

Depending on your business structure, an S-Corp can be a great way to keep your profits tax-free. The S-Corp will not withhold income tax when you distribute the earnings to shareholders. This is much easier than changing employee salaries and payroll taxes. You can distribute a small quarterly profit to your shareholders or make a substantial one-time payment to employees at year’s end. Keeping track of these details can be confusing. But, it is worth it for the tax advantages. You’ll be glad you did.

The IRS has many requirements for qualifying as an S-Corp. For example, shareholders can’t be foreigners, and all owners must be U.S. citizens or permanent residents. You also can’t transfer ownership to anyone other than specified individuals, trusts, or estates. And, if you fail to adhere to these rules, the IRS will revoke your S-Corp status. Lastly, your income and losses must be allocated proportionately to the percentage ownership of each shareholder.

Splits Profits Between Salary Wages and Dividends

If you’re the owner of an S-Corp, you must report your profits as “dividends” and not as salary wages. This is because your salary wages are subject to FICA taxes. These taxes are 12.4% of your wage base plus 2.9% Medicare tax on unlimited income. In addition, there is a 0.9% surtax on income over $200,000 that you must pay. While these taxes are low initially, they increase as your income exceeds a certain level.

An owner-employee can only earn up to the Social Security wage base. Therefore, his $10,000 distribution will have an additional tax of $1,500 on it. In other words, he will not be able to take the money tax-free. However, there is a drawback to this: the S-Corp can’t pay its owner-employees more than the maximum Social Security wage base. This is because they’re not considered “employees” for purposes of the retirement account contribution limits.

Another issue with S-Corp income is taxation. While it is true that dividends are exempt from FICA taxes, wages paid to owners are taxable. As a result, the optimal split for an S-Corp should not be determined by a percentage of profits. Instead, the optimal break should be based on reasonable compensation, and the excess should be paid out as profits.

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