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Good question and I'll answer it in two parts.
Part 1:
As an S corporation owner, you must give yourself a reasonable compensation for services you provide to your corporation.
Your corporation is able to deduct your officer salary, along with the associated employer payroll taxes assessed on this salary, as business expenses.
These business expenses lower your corporation's net profit which in turn lowers the amount of personal income tax that you will pay on the net profit.
Example:
John Smith is the sole owner-officer of his S corporation XYZ Inc.
He has determined that he should pay himself $100,000 as reasonable compensation.
His corporation grossed $1M and had $500,000 of overhead expenses.
His net profit is $500,000.
However, he is able to deduct his salary and payroll taxes which total $107,650 (I only used FICA and Medicare as employer payroll taxes).
Now his net profit is $500,000 - $107,650 = $392,350
So instead of paying tax on $500,000 of net profit, he is paying tax on $392,350.
You may ask yourself "Why do I have to pay personal income tax on my corporation's net profit?"
An S corporation is a pass-through entity which means that the S corporation (on the Federal level) does NOT pay any tax to the government.
Instead, the net profit is passed on to you, the officer-shareholder of the corporation.
Part 2:
The net profit from your S corporation is NOT subject to self-employment tax.
You only pay Social Security(FICA) and Medicare on the reasonable compensation amount.
If you were a sole proprietor/Sch C business owner, ALL of your net profit is subject to self-employment tax.
So depending on the amount of your reasonable compensation and your net profit, you would besaving on paying the government self-employment tax.
Let's revisit my example above.
The total amount of Social Security and Medicare that John would have to pay on his $100,000 reasonable compensation salary is $15,300.
The $392,350 net profit is NOT subject to self-employment tax.
If John Smith was a sole proprietorship, his net profit would be $500,000. The self-employment tax rate is 15.3%.
For 2024, the first $168,600 of net earnings is subject to Social Security. There is no cap for Medicare.
So in this example, John would have to pay $20,906.40 of social security + $14,500 of Medicare = $35,406.40.
That's a lot of self-employment tax!
So John Smith saved $20,106.40 by operating his business as an S corporation and giving himself reasonable compensation.
