Converting your sole proprietorship (Schedule C) to an S corporation can lead to significant savings on self-employment taxes. Here's how:
1. Understanding Self-Employment Taxes:
As a sole proprietor, you're responsible for paying self-employment taxes, which cover Social Security and Medicare contributions. The self-employment tax rate is 15.3% of your net earnings. This rate comprises two parts: 12.4% for Social Security and 2.9% for Medicare. In this setup, you're essentially paying both the employer and employee portions of these taxes.
2. S Corporation Structure:
An S corporation allows business owners to divide their income into two categories:
- Salary: A reasonable compensation for the work you perform for the corporation.
- Distributions (Dividends): The remaining profits distributed to you as a shareholder.
3. Tax Implications:
- Salary: Subject to standard payroll taxes (Social Security and Medicare), similar to any employee compensation.
- Distributions: Not subject to self-employment taxes; only federal and state income taxes apply.
4. Potential Tax Savings:
By allocating a portion of your business income as distributions, you can reduce the amount subject to self-employment taxes. For example, if your business earns $100,000 and you pay yourself a $60,000 salary, the remaining $40,000 can be taken as a distribution, potentially saving you approximately $6,120 in self-employment taxes (15.3% of $40,000).
5. IRS Scrutiny:
It's crucial to set a "reasonable" salary for yourself. The IRS requires that S corporation owners pay themselves a fair wage for the work performed. Setting an unreasonably low salary to maximize distributions can attract IRS audits and potential penalties.
6. Additional Considerations:
- Administrative Responsibilities: Operating as an S corporation involves more administrative tasks, such as maintaining corporate records, holding regular meetings, and filing separate tax returns.
- State Taxes: Some states impose additional taxes or fees on S corporations. For instance, in California, S corporations are subject to a 1.5% tax on net income, with a minimum franchise tax of $800 annually.
In summary, converting to an S corporation can offer substantial self-employment tax savings by allowing income to be split between salary and distributions. However, it's essential to navigate this structure carefully to comply with IRS regulations and consider any additional administrative and state tax implications.
