How Does an S Corporation Save You Money

How does an S Corporation save you money? The first question you should be asking is what is an S corporation? An S Corporation is an entity – could be an LLC, or an actual corporation – that files that election with the IRS to be taxed as an S corporation. Once you’re an S corp, you file that election and you are treated as an S Corp for federal tax purposes. A lot of states automatically treat you as an S corp as well. But you may need to check the particular state or states that you’re operating in to make sure you don’t need an election with that state as well.

An S corp can be a single owner. It does not need to have multiple owners. Sometimes people will create LLC and then decide that they want to make this S corp election. They’re the only people working in the business and the only owner of the business. So that is an option for some people to use and help maybe save some tax monies. 

How is an S Corporation Taxed?

If you’re an LLC that elects to be an S corp, that’s just for tax purposes. You don’t lose the legal identity of the LLC as an LLC, it retains that legal structure. If you were a sole proprietor that was not an LLC and wanted to become an S corp, then you would have to create a legal structure in order to do that. You cannot go right from a sole proprietor to an S corp without creating a new entity.

So an S Corp is what you’ll hear in the world of accounting and tax as a pass through entity. And basically what that means is that the activity of the company is reported to the IRS, but it’s then not subject to tax and the net activity is passed through on a form to the individual and the individual pays the tax at the individual level. The S corp has a separate filing requirement but is not taxed until activity all passes out. Then you report that on your personal income tax return.

The Multiple Identities of S Corp Owners

As an owner/operator of an S corporation, owners have multiple hats that they need to wear. The first hat is obviously the owner hat. They own the business and they operate the business. The second hat is an employee hat. They’re doing some sort of role within the company that would require some sort of pay as an employee for that company. It’s very important to understand that you have these two roles. And it is necessary to run payroll or pay yourself as an owner/operator and employee of the company. Anytime you’re performing services as an owner of an S corp, you have to take what’s called a reasonable salary. 

You have to have a reasonable set salary for what you do in the business. That is all reported on a W-2 as if you work for some other company as a non owner. That W-2 is reported on your personal tax return. You get treated as an employee in that sense and that is a deduction for the company. Then the company has the remaining net income at the end of the year that would be subject to taxes. That net income is subject to taxes as well. So not just the W-2 but the net income of the business is subject to taxes. 

How Does an S Corporation Save You Money?

Let’s talk about how the S corporation ownership net income is taxed. How is that K-1, net income, pass through activity subject to taxes? This is where potentially there could be tax savings for you, if you’re wondering is s corp worth it.

With a regular pass through entity (partnership, sole proprietor, etc) the entire net income that is allocated to you is subject to self employment taxes. That self employment tax is the FICA and Medicare tax that you would pay as an employee and as an employer. Being self employed, you wear both hats, the employer and the employee. 

With an S corporation, the net income that is passed to you in the K-1 is not subject to self employment tax, only subject to regular income tax purposes. Where the savings is, is that you have net income that’s not subject to self employment taxes as an S corp. But if you’re a sole proprietor or partnership, you would need to pay that self employment tax. 

That’s why the reasonable salary component of all this is so important. Running a reasonable salary in the eyes of the IRS helps solidify the work that you’re doing within the company that you’re getting paid for. Then you have a piece that’s considered the return on your investment. That is why that net income is not subject to self employment taxes, it’s a return of your investment, and can help save you tax money.

That return on investment (the net profit) is not taxed when you take it out of the company as you’ve already paid regular income taxes on it. 

Conclusion

Today we talked about what an S corporation is. Then we discussed the two different roles a business owner has within a company – owner/operator – and having a role within the business and then the investor role. Finally we discussed how that net income from that S Corp passes through to you and  how can an s corp save on taxes.

Please join us for our upcoming masterclass to learn even more accounting tips for you and your business.