The benefits of an S corporation for the self-employed and small business owners

by J. Christian Manalli, Partner, SFBBG

J. Christian Manalli is a partner in the Chicago law firm of Schoenberg Finkel Beederman Bell Glazer LLC. Manalli concentrates his practice on federal tax, estate planning, probate and general business matters. Manalli can be reached at 312- 648-2300, or by email at christian.manalli@sfbbg.com.

For small business owners, paying taxes can feel like a heavy burden. However, operating as an S Corporation offers a unique legal way to reduce your federal tax bill. By splitting your business income into a salary and shareholder distributions, you can save thousands of dollars every year on employment taxes.

When you operate as a sole proprietorship or a standard Limited Liability Company (LLC), the IRS views you as self-employed. This is also true for multiple owners of an LLC which is taxed by default as a partnership. This means you (and your partners) must pay 15.3 percent in selfemployment tax on 100 percent of your net business earnings. This tax consists of 12.4 percent for Social Security and 2.9 percent for Medicare. As a result, if your business earns $100,000 in net profit, you will owe 15.3 percent on that entire amount, regardless of how much money you actually take out of the business for personal use.

Forming an S Corporation or electing S Corporation tax status for your existing LLC changes how the IRS treats your income. Instead of being classified strictly as selfemployed, you become an employee-owner of your own company. This allows you to split your business income into two distinct categories. First, you pay yourself a regular W-2 salary through a standard payroll system, which is subject to the 15.3 percent FICA payroll tax. Second, any remaining profit after your salary and business expenses is passed through to you as a shareholder distribution. This money is subject to ordinary income tax, but it is completely exempt from the 15.3 percent employment tax.

To see the financial impact, compare a standard LLC taxed as a sole proprietor (or partnership) to an LLC taxed as an S Corporation with each earning $100,000 in net business income. As the owner of a standard LLC or sole proprietor, you pay the 15.3 percent self-employment tax on the full $100,000, resulting in an employment tax bill of roughly $15,300. As an LLC taxed as an S Corporation, you could set a salary of $60,000 and take the remaining $40,000 as a distribution. In this scenario, you only pay the 15.3 percent payroll tax on the $60,000 salary, which equals $9,180. The $40,000 distribution faces $0 in employment taxes, dropping your total employment tax bill to $9,180 and saving you $6,120 in a single year.

This tax strategy hinges entirely on one critical rule: you must pay yourself a “reasonable salary.” The IRS is well aware that business owners want to minimize their salary to avoid taxes, so they strictly enforce this guideline. A reasonable salary is defined as what an independent company would pay an outside person to do your exact job. To determine a defensible salary, you must consider your specific duties, your experience, your time commitment, the local market rate for your position and what similar businesses pay for comparable services. If you set your salary too low, the IRS can recharacterize your distributions as wages, hit you with back taxes and apply penalties and interest.

Ultimately, an S Corporation tax election is a powerful tool to preserve your hardearned profit. The only downside is the added cost of hiring a payroll company to assist you with collecting and reporting payroll taxes.

If forming an S Corporation or electing S Corporation tax status for your LLC sounds like a good opportunity for you, I recommend working with an attorney or certified public accountant to make the election and to establish a reasonable salary. If you have any questions about the tax election or implementing it in your own business, please feel free to contact me.