How Conducting Your Business as an S Corporation Helps Reduce Your Taxes
Is your business run as a sole proprietorship or a wholly owned limited liability company (LLC)? This subjects you to both income tax and self-employment tax, but you may be able to lower your tax bill by conducting business an S corporation instead.
The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for Social Security, up to a maximum of $137,700 for 2020, and at a 2.9% rate for Medicare. There is no maximum tax limit for Medicare tax. An additional 0.9% Medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases.
If your business is a partnership in which you’re a general partner, you are subject to the self-employment tax on your distributive share of the partnership’s income as well as income tax.
S Corporation Taxes
If the business is an S corporation, you’re subject to income tax on your share of the S corporation’s income, but not self-employment tax.
An S corporation isn’t subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss and deduction pass through to the shareholders. By conducting business as an S corporation, you may be able to avoid self-employment income tax because the income passed through to the shareholder isn’t treated as self-employment income.
As an S corporation, the IRS requires that you receive a reasonable compensation for your services. The compensation is treated as wages subject to employment tax, which is equivalent to the self-employment tax. If you are not paid a reasonable compensation, the IRS may treat some of the S corporation’s distributions to you as wages and impose Social Security taxes on the amount it considers wages.
There’s no specific formula to determine what is reasonable compensation. Reasonable compensation is the amount that unrelated employers would pay for comparable services under similar circumstances. There are various factors that should be taken under consideration in making this decision.
Converting from a C Corporation to an S Corporation
Converting a C corporation to an S corporation can cause complications. A “built-in gains tax” may apply when appreciated assets held by the C corporation at the time of the conversion are subsequently disposed of. You may be able to reduce its impact, though.
An S corporation isn’t usually subject to tax, but when a C corporation converts to S corporation status, a tax at the highest corporate rate (21%) is imposed on the net built-in gains of the corporation. This is to prevent the use of an S election to dodge tax at the corporate level on the appreciation that occurred while it was a C corporation. The tax is levied when the appreciated assets are sold or disposed of during the five-year period after the S election takes effect.
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