Someone once remarked, "Next to being shot at and missed, nothing is quite so satisfying as an income tax refund."
no question that saving money on taxes is high on everybody's list of
financial priorities--especially self-employed business owners.
unlike individuals who work as employees, business owners actually have
the "luxury" of choosing how much in taxes they pay each year by
picking one form of business entity over another--such as a sole
proprietorship, partnership, corporation, or limited liability company.
the majority of business owners choose a business entity once--usually
when starting out--then keep the same entity for the life of the
This isn't necessarily always the smartest thing to do.
some companies can get away with sticking with the same form of
business entity throughout the life of the business, countless others
are just throwing money away by paying more in taxes than they have to.
some smaller business owners, this financial nonchalance can actually
cost an extra several thousand dollars in unnecessary--and
avoidable--taxes each and every year.
you're a business owner concerned about reducing your tax liability,
here's a way you can dodge the tax bullet by utilizing what's known as
a Subchapter S corporation:
First Some Background
starting a new business most entrepreneurs focus on simplicity: that
is, the less paperwork and regulations to contend with the better. What
this means is that most new businesses start out as "unincorporated"
entities such as sole proprietorships (73%) and partnerships (6%).
management and administrative costs of running the business might be
easier and less expensive initially, the tax burden--especially the
self-employment tax--can be anything but.
many business owners who wait until year-end to do their tax
planning--or who do no tax planning at all--the self-employment tax is
an unwelcome surprise--and a very large expense.
self-employed individuals are shocked even more once they realize that
they're responsible for the self-employment tax all on their own.
That's because when they worked as an employee their employer was
responsible for paying one half of the self-employment tax.
Self-Employment Tax Particulars
- The self-employment tax is simply a version of the same Social
Security and Medicare taxes you pay as an employee. However, instead of
paying 7.65% as you do when you're an employee, as a self-employed
business owner you have to pay double: 15.3%.
- In 2004, the Social Security portion (12.4%) is levied on the first
$87,900 of net profits. There is no limit to the Medicare portion
- Self-employed individuals are also entitled to a one half-credit of the tax.
- As an example, a self-employed individual with $100,000 in net
profits in 2004 would be required to pay approximately $12,766 in
NOTE: This tax is in ADDITION to federal, state and local taxes!
Here's What You Can Do to Save on the Self-Employment Tax
Incorporate and elect Subchapter S status. You can elect Subchapter S status even if you have a pre-existing C corporation.
your business as an S corporation is one of the very few four leaf
clovers still left in the tax code. The reason for this is simple: The
net income from an S corporation is NOT currently subject to the
structured and implemented properly, an S corporation could save you
thousands of tax dollars per year. As an employee-shareholder of your S
corporation, you pay yourself wages just like you would any other
But instead of taking profits out through payroll, you take cash distributions called nontaxable dividends.
dividends are called nontaxable, because they aren't double taxed like
the dividends paid to shareholders in a regular C corporation (although
beginning in 2008 most dividends will no longer be taxed).
still paying taxes on the net income of your S corporation when you
file your personal tax return, but the tax is federal tax and NOT the
the sake of simplicity, if an S corporation with $100,000 of pre-tax
and salary profits pays its owner a reasonable salary of say $50,000
and non-taxable dividends of $25,000, the tax would be $7,650.
This is a whopping $5,116 savings in tax compared to the $14,060 a sole proprietor would pay on profits of $100,000!
if you factor in additional costs such as workman's comp insurance,
incorporation costs, professional fees and incidentals, the savings is
still more than adequate.
- The key to successfully implementing this strategy is that your
salary must be REASONABLE under the circumstances surrounding your
business. It's also much better for salary justification purposes if
your business is not limited to the delivery of personal services by
- At personal income levels close to the Social Security wage base
($90,000 for 2006), the benefits of using this strategy diminish.
But Here's Some More Good News
you happen to already own a regular C corporation and you live in a
state that has a high corporate income tax rate and a low personal one,
you'll come out ahead even more if you elect S status.
if you have children aged 14 or older, you can save even more taxes by
giving them shares in your S corporation and having them pay the tax at
their lower tax rates.
By giving away shares you also reduce your estate tax obligation.
So you see, there are plenty of good reasons to incorporate and elect S status. I've only touched on a few minor points.
keep in mind that you should ALWAYS consult with your tax advisor and
attorney before making any important business or financial decision.
Your financial situation is unique and the information in this article may not be appropriate for your particular situation.
Always look before you leap.
it comes to your business, you should make it a point to assess the
validity of your type of business structure on a yearly basis.
is definitely not just for startups. There are plenty of unincorporated
businesses that are missing the boat when it comes to saving money.
Don't be one of them.