An S Corporation Could Cut Your Self-Employment Tax

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17 May An S Corporation Could Cut Your Self-Employment Tax

If your business is organized as a sole proprietorship or as a wholly owned limited liability company (LLC), you are subject to both income tax and self-employment tax. There may be a way to cut your tax bill by conducting business as an S corporation.

Fundamentals of Self-Employment Tax
The self-employment tax is imposed on 92.35 percent of self-employment income at a 12.4 percent rate for Social Security up to a certain maximum ($142,800 for 2021) and at a 2.9 percent rate for Medicare. No maximum tax limit applies to the Medicare tax. An additional 0.9 percent Medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases.

What if you conduct your business as a partnership in which you are a general partner? In that case, in addition to income tax, you are subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation, you will be subject to income tax, but not self-employment tax, on your share of the S corporation’s income.

An S corporation is not subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you may be able to avoid self-employment income tax.

Keep Your Salary ‘Reasonable’
Be aware that the IRS requires that the S corporation pay you reasonable compensation for your services to the business. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax. If the S corporation does not pay you reasonable compensation for your services, the IRS may treat a portion of the S corporation’s distributions to you as wages and impose Social Security taxes on the amount it considers wages.

There is no simple formula regarding what is considered reasonable compensation. Presumably, reasonable compensation is the amount that unrelated employers would pay for comparable services under similar circumstances. There are many factors that should be taken into account in making this determination.

Converting From a C Corporation
There may be complications if you convert a C corporation to an S corporation. A ‘built-in gains tax’ may apply when you dispose of appreciated assets held by the C corporation at the time of the conversion. However, there may be ways to reduce its impact.

Many Factors to Consider
Contact us if you would like to discuss the factors involved in conducting your business as an S corporation and how much the business should pay you as compensation.