How can an S Corporation save me in federal taxes? This is an interesting question, and one that comes up frequently with the business owners and entrepreneurs with whom we work. Warning: I’ve got to nerd out a little here to answer the question, but I’ll try to make it painless. Please note: I ignore state income taxes because, mercifully, we pay none in Florida. I also ignore the new Business Net Income tax deduction for 2018. It should apply equally to all pass-through entities, which is what I’m considering here. Since no one has seen that tax in action, as it were, I’ll leave it out of my considerations for now.
Three Types of Income
For our purposes here, let’s consider three types of income: W-2, 1099, and dividend income. W-2 income is that which you receive from your employer. Your pay stub will show your gross wages for the period, and tax withholding. The tax withholding is both federal and FICA. The FICA tax is 7.65% of your gross income during the period. Your employer also deposits an equal amount with the IRS, making the total FICA rate 15.3%.
1099 income is that which you pay yourself as a sole proprietor. Nothing is withheld for taxes at the business entity level. You are responsible for making quarterly tax payments to the IRS.
Dividends are distributions of profits from corporations to shareholders. If you are in the 10% bracket, dividends and capital gains are not taxable to you. In the top 37% bracket, dividends and capital gains are taxed at a flat 20% rate. If you’re in the middle, the rate is 15%. Dividend income is not subject to payroll taxes.
Self Employment Taxes
Self employment tax is charged against all income up to $128,400 (2018). The 7.65% consists of 5.4% for Social Security, and 2.25% for Medicare. The $128,400 is the top amount on which Social Security is taxed. Above that, only Medicare tax. (There are additional Medicare taxes which kick in at higher income rates.)
If I own my own company, I pay both sides of that tax – the employer (ER) and the employee (EE), since I am both. That means I pay 15.3% of something as FICA tax. So what’s the something?
If I am a sole proprietor or LLC owner taxed as a proprietor, my social security number is the taxpayer ID number of my company. I pay self-employment tax, which is 15.3% on my company’s net earnings. The advantage, though, is that I get to deduct ½ of that amount – 7.65% – above the line on my form 1040. Also, as a sole proprietor, I deduct medical insurance expenses here and not on my Schedule A, which is a big advantage. I also deduct my self-employed retirement contributions here.
If I own an S corporation, then I am no longer a proprietor, but rather an employee of a corporation – my own corporation. Now I am paid as an employee, with both Federal and FICA (Federal Insured Contributions Act) taxes withheld from my paycheck. Since I am not self-employed, I cannot take an above the line deduction for my retirement plan contribution. All legitimate business expenses get deducted from the business gross income to arrive at its net income. If I use a SEP IRA, the contribution is made by the employer (who is me) to my account. The SEP contribution can be as much as 25% of my W-2 wages. Both my retirement and health insurance premiums are paid by my corporation on my behalf on a tax-deductible basis.
Where’s the advantage?
At the end of this piece I’ve attached a table showing an analysis of taxation for a married couple with two young children, filing jointly, with a single taxable business income of $200,000. There is a clear tax advantage to the corporate owner who takes half of his compensation as salary, and half as dividend distributions.
Mixing W-2 with Dividend Income
This is the crux of the matter. Dividends are taxed to most taxpayers at a flat rate of 15%. The tax tables are as follows:
- $0 – $19,050, 10%
- $19,051 – $77,400, 12%
- $77,400 – $165,000, 22%
- $165,001 – $315,000, 24%
- $315,100 – $400,000, 32%
- $400,001 – $600,000, 35%
- Over $600,000, 37%
Look at how the rates graduate. Once your taxable income exceeds $77,400, meaning you go into the 22% marginal rate, you’d rather have dividend distributions than wage income, wouldn’t you? Well, if you own your own corporation, you can!
Look again at that tax comparison table (below). In the last column I assumed our business owner paid himself $75,000 as W-2 income and $75,000 as dividend income. This scenario saves him $11,403 over what he’d pay as a sole proprietor – a 25%% decrease. Who wouldn’t want that?
What does the IRS allow regarding the ratio of W-2 to dividend income for the S corporation owner? Believe it or not, there is no specific guidance that would indicate ratios. Tax preparers differ as well. Many use the Social Security wage base as the place up to which to pay W-2 income, and then dividend distributions above that. Doing so will ensure the top Social Security benefit is paid in retirement. Others are more aggressive and will have their clients take a much larger proportion of their income as dividends.
Taxes aren’t the only reason for choosing the legal entity for your business. All businesses have some type of potential liability. If you own your business outright as a proprietor, and someone wins a liability judgement against you, your personal assets with a few exceptions are open to your creditors. Clearly pretty much any business should have liability insurance.
You may continue to be taxed as a proprietor but with a Limited Liability Company Structure. Both as an LLC and as an S corporation (technically a regular corporation with a subchapter S election) all business taxes flow through to your individual return. These provide even more protection from liability claims, as a creditor can only get at assets owned by the LLC or the corporation.
Which Business Entity is Best?
Which business entity is best? It depends upon your individual facts and circumstances. Consult with qualified tax advisers who can thoroughly assess your situation and make a good recommendation.
|Mr. & Mrs. Client, married filing jointly|
|Two young children|
|Sole||S Corporation||S Corporation|
|Proprietor||All Salary||1/2 and 1/2|
|Gross Taxable Income||$165,371.90||$176,000.00||$68,350.00|
|Total Federal Tax Due||$28,267.90||$30,818.64||$6,369.00|
|Total Self Employment Tax Due||$21,256.20||$0.00||$0.00|
|Total Dividend Tax Due @15%||$11,250.00|
|Gross Tax Due||$49,524.10||$30,818.64||$38,120.88|
|less two child credits @ $2000/each||($4,000.00)||($4,000.00)||($4,000.00)|
|= Total Net Tax Due after Credits:||$45,524.10||$26,818.64||$34,120.88|
|Payroll Tax paid by EE and ER||$0.00||$21,256.20||$0.00|
|Total taxes paid by entity plus owner:||$45,524.10||$48,074.84||$34,120.88|
Glenn J. Downing is a CERTIFIED FINANCIAL PLANNER™ professional and co-founder of CameronDowning, a Registered Investment Advisory Firm in Miami, FL. Please connect with us on LinkedIn, Facebook, Instagram, and Twitter. Also, check out the rest of the CameronDowning website where you can see dozens of short videos answering many of your personal financial questions. Feel free to email questions to [email protected]