S Corporations Help Small Business Owners Save On Taxes
Vice presidential candidate John Edwards saved $600,000 with his S Corporation
Vice presidential candidate John Edwards saved $600,000 in taxes by forming an S corporation (also known as a subchapter S corporation). How can an S corporation help you?
Edwards made $26.9 million as a trial lawyer in 1995, and he minimized paying Medicare taxes by forming his own S corporation. Edwards paid himself a salary of $360,000 each year for four years and had the S corporation pay him the rest in dividends.
Salary is subject to Medicare taxation at a rate of 2.9%, but dividends escape Medicare taxation. There is no wage base for Medicare, all wages or salaries are subject to the full 2.9% tax. Social Security does have a wage base, which means wages above some limit (currently $87,900) are exempt from the Social Security tax.
So, Edwards saved 2.9% of $25,460,000 or $738,000 in Medicare taxation. However, sole proprietorships are allowed to deduct one half of what they pay in Social Security taxes from their income tax (sole proprietors file Schedule C along with their personal 1040 tax returns). Thus, had Edwards operated as a sole proprietor, he'd get a deduction for $369,000 from his income tax. Figuring income tax at the then-current 39.6% rate, he'd reduce his income tax by about $146,124 if he had filed as a sole proprietor.
Thus, Edwards net savings for forming the S corporation were about $591,000.
Reducing Social Security taxes with an S Corporation
S corporations are useful for small business owners who want to semi-opt-out of the Social Security System. But, the law requires that S-corporation owners pay themselves a reasonable salary for the work they do. Officers of a corporation are considered employees.
Edwards paid himself $360,000 which is probably considered a fair base salary for a successful attorney. And, because his salary was above the Social Security wage base, he paid the maximum required by Social Security.
If an entrepreneur earns $80,000 per year and can justify paying a salary of $40,000 with the remaining $40,000 paid in S-corporation dividends, Social Security and Medicare taxes are reduced by about $6,000. Over a thirty-year work history, when investing and compounding are considered, that can amount to having well over a million dollars more in retirement funds. This is a big advantage of forming an S corporation.
In deciding what's a fair wage, several factors can be considered.
- How much time and work is involved? Somebody working part time can justify a lower salary than somebody working full time.
- How much do entrepreneurs and other people doing similar jobs earn? If your salary is comparable to others doing similar jobs that tends to show your salary is appropriate.
What the IRS definitely doesn't want to see is an entrepreneur working full time, raking in $100,000 per year, paying wages of only $5,000, and removing the rest of the earnings as S-corporation dividends.
Comparing an S Corporation to a LLC or sole proprietorship
Money retained within an S corporation isn't subject to Social Security or Medicare taxation. If you plan to reinvest your earnings in your company, this is one potential disadvantage of operating as a sole proprietor or as a Limited Liability Company (LLC), because the net income of sole proprietors and active members of an LLC is subject to Social Security and Medicare taxation. Operating as an S corporation will give you more money to reinvest. The downside is that you'll have smaller Social Security benefits in the future.
Peter Hupalo, author of
How to Start And Run Your Own Corporation: S-Corporations For Small Business Owners