You probably hear about S-Corp tax savings all the time, as a solopreneur. Has anyone ever broken it down for you? Look no further. Here is how S-Corp owners pay less tax than sole proprietors.
It most comes down to self-employment taxes, although there are some opportunities for tax savings with Solo 401k plans. In a sole proprietorship all of your income is subject to self-employment taxes. In an S-Corp you can choose to split your income into two buckets: wages and business profits. Only wages are subject to self-employment taxes. You might be asking, “Well, why not just categorize everything as business profits?” The IRS already realized that you would try to take advantage of that. They require that you pay yourself a “reasonable salary,” although they do not give an objective definition of what that is. You should discuss this reasonable salary with your tax professional before you implement your strategy.
Now, onto the tax difference. If you have a sole proprietorship with $75,000 in net income you will owe $10,597.16 in employment tax. That’s 15.3% on your net income after your 1402(a)(12) deduction. You also deduct 1/2 of your self-employment tax on your tax return. If you have an S-Corp with $75,000 in net income and you decide that 50% of that is a reasonable salary, you owe $5,737.50 in employment tax. Your S-Corp gets to deduct 1/2 of that on its tax return, too. That’s a difference of $4,859.66.
There are some extra expenses and work to maintain an S-Corp (or an LLC taxed as an S-Corp), so this strategy does not work for everyone. The general rule of thumb is that if you consistently make over $50,000 per year then it is worth choosing S-Corp taxation. Of course, you should strategize with your tax professional before implementing this. Once you do you will see why S-Corp tax savings are so often discussed.
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