|How to Save Taxes with an S
by Stephen L. Nelson, CPA
Ever wondered why so many small businesses--more
than 3,000,000 at last count--operate as an S corporation? Simple. An S
corporation saves business owners big taxes in three separate
First, as compared to regular corporations (sometimes called C
corporations), S corporation owners can use the business's losses incurred
during the early lean years on the owner's personal returns as
For example, suppose a new S corporation suffers a $20,000
loss its first year and that the corporation is equally owned by two
shareholder-employees, Smith and Jones. Smith and Jones each get a $10,000
business deduction on their individual tax returns because of the S corporation
loss. This $10,000 deduction might save them each as much as $4,000 in federal
and state income taxes.
A second, big S corporation benefit: As compared
to almost every other business form, S corporations can save their owners
self-employment or Social Security/Medicare taxes.
Suppose, for example,
that Adams, Brown and Cole independently each own businesses that make $90,000
a year in profits. Each business owner may pay $13,000 in income taxes. But,
unfortunately, that's not the only tax they pay. Each owner also pays
self-employment or Social Security/Medicare taxes.
For example, Adams
operates his business as an LLC and therefore pays 15.3%, or roughly $13,500,
in self-employment taxes on his profits.
Brown operates his business as
a C corporation which pays all of its profits to him as a salary. Accordingly,
Brown (through his corporation) also pays 15.3%, or roughly $13,500, in Social
Security and Medicare taxes.
Cole's situation is different. Cole
operates his business as an S corporation which means that Cole can split his
$90,000 of profits into two payment amounts: salary and S corporation
Suppose that Cole says only $40,000 of his profits are
salary and takes the other $50,000 as a "dividend" distrbution. In this case,
Carter pays the 15.3% Social Security/Medicare tax only on the $40,000 in
salary. Carter therefore pays roughly $6,000 in Social Security/Medicare
taxes--and annually saves $7,000 in taxes as compared to Adams or
S corporations also, sometimes, provide a third form of tax
savings because S corporations don't pay corporate income taxes. This means
that S corporations avoid the often-talked about "double-taxation" problem.
However, the "no corporate income taxes" benefit often isn't a savings for
small corporations and their owners.
But let me explain. Suppose that
two corporations each earn the same pretax profit of $100,000 and are owned by
Ms. DaVinci who pays the highest federal income tax rate of 35%. One
corporation is an S corporation and the other is a C corporation.
corporation can distribute the entire $100,000 in profits to DaVinci as
dividends because there is no corporate income tax. DaVinci then pays $35,000
in personal income taxes on the S corporation profits, which means she nets
$65,000 in after-tax profits from the S corporation.
In comparison, the
C corporation can't pay the entire $100,000 in profits to DaVinci. The C
corporation first pays $22,250 in corporate income taxes. When the C
corporation pays the remaining $77,750 to DaVinci as a dividend, DaVinci pays
another $11,663 in 15% "dividend" taxes on the C corporation profits. This
means that DaVinci nets roughly $66,000 in after-tax profits from the C
corporation profits. In this case, DaVinci saves money with a C corporation in
spite of having to pay the corporate income tax.
How to Get S
To create an S corporation and receive S
corporation tax savings, you need to do two things: First, you must incorporate
the business either as a regular corporation or as a limited liability company.
Second, you need to make an election with the IRS to have the corporation or
LLC treated as an S corporation. The S election is made with form 2553,
available from the www.irs.gov web site. Note that some states (such as New
York) require a separate state S election.
A final tip: S corporations
can save you thousands of dollars annually, but your tax savings can't start
until you elect S corporation status. If you're interested is electing S status
to save on taxes for next year, you may want to call your tax advisor or
attorney right now!
Bellevue WA CPA Stephen L. Nelson is the author of both
Quicken for Dummies and QuickBooks for Dummies and an adjunct tax professor for
Golden Gate University's graduate tax school.
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