There are several advantages to forming a business entity. It protects your personal assets, gives you more financial visibility, and can make it easier to manage your taxes. If you choose the right type of corporate structure, you can significantly lower your yearly tax bill.
The easiest way for most business owners to reduce tax bills is to be taxed as an S Corporation. You can do this either by:
- Forming an S Corporation.
- Forming a Limited Liability Company (LLC) but electing to be taxed as an S Corporation.
Reduce Self-Employment/Payroll Taxes by Being Taxed as an S Corporation instead of a Sole Proprietorship or Partnership.
To understand why getting taxed as an S Corporation is more tax effective, it’s useful to understand the types of taxes you will need to pay.
Employment, Payroll, and Self-Employment Tax
This is a tax levied on the salary of everyone in your business, even if you are self-employed. There are two parts of this tax, that paid by the employer, and that paid by the employee. If you are self-employed you have to pay both the employer and employee portion, which was 15.3% in 2016.
This tax is also known as the FICA, Medicare, or social security tax and is levied on your entire income. For example, if you pay yourself $50,000 as salary, you will pay around $7,500 in this tax.
Federal Income Tax
This is tax you have to pay on any profit your business makes (revenue less expenses). There are standard and other deductions you can apply to this amount, and the total you end up paying will depend on your tax band. You will pay federal income tax on your salary, in addition to employment tax.
Differences Between Paying LLC Taxes and Paying S Corporation Taxes
- If you are taxed as a standard LLC (not taxed as an S Corp), you have to pay employment tax on your entire salary.
- If you are taxed as an S Corporation, you can choose to take money out of the business in two different ways:
- As a salary — You will pay employment tax on this as normal.
- As a distribution — You will only need to pay federal income tax on this.
The differences can be substantial. For example, if you take $70,000 out of the business, as a standard LLC you would pay $10,710 in employment tax. In contract, if you took out $45,000 as salary, and $25,000 as distributions, you would only pay $6,885 in employment tax, a saving of $3,825.
The S Corp Tax Calculator
The S Corporation tax calculator lets you choose how much to withdraw from your business each year, and how much of it you will take as salary (with the rest being taken as a distribution.) It will then show you how much money you can save in taxes.
To use the Calculator please visit our site here
Forming an S Corp versus Forming an LLC and Getting Taxed as an S Corp
If you want to take advantage of these tax rules, you can either form an S Corporation, or form an LLC and choose to be taxed as an S Corporation (subchapter S tax election status). Many of our clients choose the latter, for several reasons:
- It’s simpler and easier to form an LLC than an S Corporation.
- Asking the IRS to consider your LLC as an S Corp for tax purposes is very simple.
- Incfile will take care of filling in the paperwork (form 2553) and file it with the IRS on your behalf.
- If you choose to form an S Corp, there are more stringent rules and regulations you will have to meet. This can result in more paperwork and higher professional fees for accountancy and legal services.
Important Points about Salaries, Distributions, S Corp Status, and Taxes
There are several areas you will need to pay attention to:
1. Reasonable Salary and Compensation
You must pay a reasonable salary as a salary (not a distribution.) The IRS does not have a clear definition of what a “reasonable salary” is, other than proper compensation for the services provided to the corporation. A good rule of thumb is to look at the “average” salary for the position and pay that as salary, with any excess being paid as a distribution. Failure to do this could result in an audit from the IRS.
2. Declaring an LLC Should be Taxed as an S Corp
Incfile can prepare your paperwork for you to be treated as an S Corp when you setup your LLC and send it to you. You will then need to add your signature and fax or mail into the IRS within 75 days of the date of incorporation to receive the tax election status for the initial year of the business. You can also choose to do this yourself at a later date, by filling in form 2553. However, remember that the IRS still must receive this form within 75 days of the formation of your LLC — whether Incfile prepares your paperwork or you do it yourself — or you will need to wait to the following tax year to make the change.