This is the third post in a series of posts about S-Corps. In the first post we explained what an S-Corp is, in the second post we explained why you should, or should not, make an S-Corp election, and in this post we will give you an example of how you can reduce your tax liability by making an S-Corp election.
The Default – 15.3%
When you earn money, the IRS expects to collect 15.3% for Social Security and Medicare.
If you are employed somewhere, you’ll pay 7.65% and your employer will pay the other 7.65%.
However, if you are self-employed, you have to pay the entire 15.3% yourself. This is true for sole-proprietors and also partners in a partnership (and also true for LLC owners if the LLC is taxed as a sole proprietorship or partnership). (There are some limits to this, plus you’ll pay various income taxes and other taxes. But we’re trying to keep things simple here.)
When you elect to be taxed as an S-Corp, the IRS will expect to collect that 15.3% on your salary, but you can pass your profits through to your personal tax return without paying that 15.3% on those profits.
That’s where the savings comes in.
15.3% of your profits can add up to a significant savings in some situations.
A Practical Example
In the example below, we show what federal taxes you’ll owe based on $75,000 in net income. This example assumes your individual tax rate is 20% and that your effective corporate rate is 22.25%. It also ignores state and local taxes.
As you can see, your tax classification will impact how much money you take home at the end of the year.
Being taxed as a sole proprietorship is the easiest, but not the most profitable. Paying taxes as a corporation looks better, but in the real world it is more expensive to operate as a corporation so you won’t really see a savings there (corporate formalities, additional state-level taxes, extra tax return filings, etc.).
However, right in the middle you’ll see how the S-Corp election can save you money. You can avoid corporate taxes and avoid the 15.3% self-employment tax on your profits. At the end of the day, at least in this example, your net take home pay will be highest by making an S-Corp election.
What This Means for You
Clearly, making an S-Corp election can result in more money in your pocket at the end of the year. But as we explained in the second post in this series, there are other reasons why you might not want to make the election.
And further, even in this “simple” example, it is all quite complicated. And there is more to it than described above. That’s why you should always talk with an accountant and a lawyer before making any tax classification decisions for your small business, especially if you are a high-growth potential startup.
*This article is very general in nature and does not constitute legal advice.