As you are most likely aware, each business structure provides a unique set of limitations and benefits. While many smaller businesses operate as sole proprietorships or general partnerships, their owners may actually be able to increase their after-tax, take-home pay by reorganizing their business. Making the transition to an S corporation (S corp) is one of the more common examples of proactive restructuring. Read ahead to find out why, then see how to get started with your reorganization process.
Benefits of incorporation
Transitioning your business from an informal structure to an S corp structure establishes your company as a separate legal entity. After incorporating, it is possible for you to serve as both an owner/investor in your new corporation while also working there as an employee. This allows you to pay yourself a salary, as well as dividends on the company’s earnings.
While it might not seem like an important distinction, the classification you choose for your earnings (either dividends or a salary) from your company does have some very real tax implications. Most notably, choosing to receive dividends rather than a salary reduces taxes, as dividends are not subject to any employment taxes. As a result, even the owners of relatively small S corporations can save thousands on overall annual personal tax expenses.
Breaking down the numbers
In order to show you how the transition to an S corp may be able to save you money, let’s examine a hypothetical company. Let’s say this business turns a yearly profit of $200,000. Each corporate structure type is taxed differently:
Informal business structure
In a sole proprietorship, the owner would claim the $200,000 as self-employment income on his or her personal tax return. On average, and depending on the state, this would cause the business owner to pay around $25,000 directly back to the government as a self-employment tax.
In an S corp, the business owner would be able to split the $200,000 net profit between two categories: a salary (paid by the business to the owner) and dividends. Assuming this sum was split as 80% salary, and 20% dividends, the employment tax liability would be closer to $21,000, a $4,000 favorable difference. The employment taxes also become an expense of the business, as opposed to a “self-employment tax”, which makes them eligible to be business deduction.
Why an S corp?
In order to reduce your overall tax burden using this strategy, it is integral that your business files as an S corp. This is due to the fact that S corps are the only corporations that are taxed on a “pass-through” basis. This means that the company is not taxed at the business level, but only on a personal basis for each owner. If your company were a C corporation, it would need to pay its taxes at the company level first, and then again when it is distributed to you (and the other owners) as dividends, negating any potential savings.
While this salary/dividend strategy is completely legal, it does have limits. Due to its potential to be abused by allocating all of a company’s income as dividends, the IRS keeps a close eye on S corps to make sure that all allocations are above board.
If it is found that you may be trying to abuse this strategy, the IRS will take a close look to see if your salary is in line with what the company reportedly pays you for your work. While this figure is open to interpretation, it is usually best to stick relatively close to what the industry average for the services you provide your business. If it is ruled that this tax savings “allowance” was abused, your company will be liable for any unethically avoided taxes, and their associated penalties.
Forming an S corp
If you have decided that the salary/dividend strategy may benefit your company (as well as your bottom line), forming an S corp is very similar to the process of founding any other corporate entity. There is a special federal form to fill out, but beyond this formality, you should only need to file the typical state formation documents. You will also be required to follow certain ongoing, and annual formalities as well. These formalities are actually less involved than those of a C corp, and only slightly more demanding than the requirements of running an LLC.
As with any financial decision, it is always an intelligent choice to talk to a licensed accountant before taking action. This is especially true for any changes that are as substantial as a complete reorganization of your company’s structure. Also, feel free to search through our learning library for a more in-depth look at the different tax implications that the numerous types of businesses face.
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