TL;DR
Palma Financial Services, Inc. recommends the S Corp (vs C Corp) to avoid self employment and minimize income taxes. Read on for the details.
Avoiding Higher Social Security and Medicare Taxes
If you’re self-employed, one way to help avoid higher Social Security and Medicare taxes is to organize your business as an S-corporation.
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
Source: I.R.S.
If you’re self-employed, you’ll usually have to pay higher Social Security and Medicare taxescollectively known as self-employment taxesthan if you were an employee of a company. However, one way to help avoid these higher taxes is to organize your business as an S-corporation. Because you could end up lowering your overall tax liability while generating the same net income, the Internal Revenue Service may take a close look at your taxes with this route though; read further.
The Down of Self-employment Taxes
Whether you’re self-employed or an employee, you’ll have to pay Social Security and Medicare taxes to the government. When you work for someone else, you’re only responsible for part of these taxes, while your employer pays the balance. However, if you’re self-employed, you have to pay both portions of this tax. The combined employee and employer portions of this tax amount normally amounts to 15.3 percent, although the rate was dropped to 13.3 percent for tax years 2011 and 2012.
The Beauty of S-Corp Distributions
If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You’ll still be liable for self-employment taxes on the salary portion of your income, but you’ll just pay ordinary income tax on the distribution portion.
Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation.
Source: Miguel Palma – Founder, Palma Financial Services, Inc.
Risks of S-Corporations
The IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $500,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a “reasonable” amount of your income as wages, rather than a distribution. What constitutes “reasonable” can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS.
This is why it’s so important to have a professional financial specialist at your side.
Additional Costs for S-Corporations
While an S-corporation may save you in self-employment taxes, it might also cost you more than it saves in certain circustances. As with larger corporations, an S-corporation has both start-up, ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors.
We Are Here To Help
We know that organizing your business can be confusing and take up too much of your valuable time. Palma Financial Service, Inc. offers the experience and common sense to help guide this process along so that your business is not paying more in taxes than what is legally required.
Contact us today for a consultation and let’s see if the S-corporation is a good fit for your business. We won’t waste your time.