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Now that I’ve mentioned tax avoidance, one potential advantage of incorporating your business into an S-Corporation is the ability to reduce the Social Security and Medicare taxes that you pay. I’m going to stick to using examples of one-person businesses.

Simple Example

Here is a simple example. Let’s say you have two self-employed people, Sam and Carrie, who are both freelance photographers. Their businesses make the same net profits of $60,000 last year ($5,000/month). The only difference is that Sam is a Sole Proprietorship and Carrie is an S-Corporation.

Because Sam is a sole proprietorship, there is no difference between him and the business. They are one and the same. Therefore he has to pay self-employment taxes (Social Security + Medicare) of 15.3% on the entire $60,000 annual net profit, or about $9,200. He also must pay federal and local income taxes on that income.

Carrie is a bit different. She incorporated her one-person business into an S-Corporation, which is a separate entity. She wears two hats: she is the sole shareholder of that corporation, and also the sole employee.

S-Corporation are a ‘pass-through’ entity, which means all the profits of the corporation pass through directly to the shareholders’ tax returns. S-Corps do not pay corporate income taxes. However, the classification of this profit also matters:

As an employee, she just assigns herself a “reasonable salary” as required by the IRS. She does some research, and finds that similar photographers in her area earn $25 an hour. $25 an hour x 40 hours a week = $1000/week, or $4,000/month. So her salary is $4,000/month.

As the corporation shareholder, she owns a business with $5,000 of overall profits each month, but also pays out $4,000 for that one extremely loyal employee. That means $1,000 per month is not paid out as salary, and will be distributed to the shareholders (her) as dividends, or unearned income.

At tax time, Carrie gets $48,000 a year in earned income as an employee, and $12,000 in S-Corp distributions as a shareholder. You only pay self-employment taxes on earned income. $48,000 x 15.3% = $7,400. She also must pay federal and local income taxes, the same amount as Sam.

So as an S-Corporation, Carrie paid $1,800 a year less than Sam in taxes.

Famous Example

The most famous example is ex-VP candidate John Edwards, who formed an S-Corporation to reduce taxes on his significant earnings as a trial lawyer.

His S-Corp earned from $5-11 million dollars a year from 1995-1998. His stated salary? A mere $360,000. Here is a New York Times article about it. Note that even in this extreme case where he saved over half a million dollars in payroll taxes, it was not found illegal:

…But even those whose business it is to collect taxes said they could find no fault with what Mr. Edwards did. “Let’s face it,” said Veranda Smith, a government affairs associate with the Federation of Tax Administrators. “I work for the state tax agencies, and I’m perfectly happy to say that anyone who puts in a structure that pays more taxes than necessary is nuts.”

Wow!

Basically, you are saving self-employment taxes on whatever profits are not counted as salary. In the past (and also in the present), aggressive business owners have tried to take all their income as dividends and receive zero salary, but the IRS has been cracking down on this. (Can you say audit flag?!)

As you can see, the benefit can be really significant as overall net profit increases. The difference between $90k salary vs. $50k salary/$40k dividends is $6,000 a year in savings. Remember, you have the right to structure your business to minimize taxes. Detractors may call it a ‘loophole’, but the fact is it is available to you now. For how long? Who knows.

The main hurdle with this strategy is that the IRS gives basically no guidance as to what is a “reasonable” salary. From the case studies that I have read, the IRS does not want to be in the position to decide what people ‘should’ earn. People who have good substantation of why they chose the salary they did have passed through audits successfully. People who didn’t and took unreasonably low salaries got their dividends recharacterized as earned income, and got charged back-taxes and penalties.

I am personally going to use Salary.com and similar data from other job sites in my area to form my salary numbers. I have met with tax attorneys and they also do not give firm guidance. They do however recommend against giving yourself zero salary.

Some CPAs use the “60/40 rule”, which says that your salary should be no less than 60% of the net profit, allowing the other 40% to be distributions. This is more of an anecdotal rule from what I have read, and has no basis from any IRS source or hard evidence that I am aware of.

I should also note that if you pay less in Social Security taxes, this may affect your future Social Security earnings in the future, as your salary is seen as lower. However, if you’re like me, you’d much rather take the money now as opposed to hoping to get it back 40 years from now.

Of course, the possible tax benefits must also be weighed against the cost of forming and maintaining corporation status, including the extra paperwork involved. If trying to save money, you can file for a corporation yourself or use a legal service like LegalZoom and others.

Keep in mind this is all based on information I gathered from the internet, tax books, and consultations with CPAs and tax attorneys. I am not a tax professional and this is not tax advice. This post also excludes many of the other advantages and disadvantages of S-Corporations over other business forms such as Sole Proprietorships, LLCs, or C-Corporations.