Hey everyone, Samir Bhatia here from BW Group! We’re a CPA firm specializing in small businesses and high-net-worth individuals, with a focus on real estate and physicians. Today, we’re diving into the world of S Corporations—a topic many of you have been asking about. Let’s break it down.
What is an S Corporation?
An S Corporation, or S Corp, is a type of corporation designed to avoid double taxation. Instead of having the corporation pay taxes, the income or losses are passed on to shareholders to report on their individual tax returns. This makes it a popular choice for small business owners.
Advantages of an S Corporation
Separate Legal Entity: Unlike a sole proprietorship, an S Corp stands as a separate legal entity. This provides some level of personal liability protection.
Tax Benefits: One of the major benefits is minimizing Social Security and Medicare taxes. By categorizing income as both salary and dividend distribution, S Corp owners can potentially save a significant amount on taxes.
Perpetual Life: The S Corp continues to exist even if an owner leaves, selling shares to new owners, which can be a big plus for business continuity.
Disadvantages of an S Corporation
Filing Requirements: Setting up an S Corp involves paperwork. You must file with the state and make an S Corporation election at the federal level.
Payroll Compliance: S Corps are required to run payroll, which adds another layer of complexity and compliance. Owners must pay themselves a reasonable salary and deduct payroll taxes.
Pro Rata Distribution: If multiple people own the S Corp, earnings and profit distributions must be proportional to ownership percentages. This can complicate things if not all owners contribute equally.
Minimizing Taxes Through S Corporations
One of the main reasons to choose an S Corp is to reduce self-employment taxes. Here’s how it works:
- W-2 Income: This piece is subject to Social Security and Medicare taxes.
- Dividend Distribution: This portion isn’t subject to Social Security and Medicare taxes.
Example: If you have $200,000 in income and $100,000 in expenses, leaving $100,000 in profit:
- Non-S Corp: You’d pay about $15,300 in self-employment tax on $100,000.
- S Corp: If you pay yourself a $25,000 salary, only this amount is subjected to Social Security and Medicare taxes. Your dividend distribution of $75,000 isn’t subject to these taxes, leading to substantial savings.
Tax Strategy Example
Let’s break this down further:
Non-S Corp:
- Income: $200,000
- Expenses: $100,000
- Taxable Income: $100,000
- Self-Employment Tax: $15,300
- Federal Income Tax: $18,000 (assuming 25% rate)
- Total Tax: $33,300
S Corp:
- Income: $200,000
- Expenses: $100,000
- Salary: $25,000 (subject to payroll taxes)
- Dividend Distribution: $75,000 (not subject to payroll taxes)
- Payroll Tax on Salary: $3,825
- Federal Income Tax: $20,400 (25% on $85,000 taxable income)
- Total Tax: $24,225
- Savings: $9,075
Costs and Setup
Setting up an S Corp involves initial costs, but it’s affordable:
- LLC Taxed as an S Corp: Around $600, covering filing fees, name reservation, and federal EIN.
- State Fees: For example, in Texas, it’s about $350. Fees vary by state.
Conclusion
An S Corporation can be a powerful tool for small business owners looking to reduce their tax burden and ensure business continuity. By understanding the advantages and disadvantages, as well as the tax strategies involved, you can make an informed decision about whether this business structure is right for you. While there are initial costs and compliance requirements, the potential tax savings and legal protections often make it worthwhile.
For personalized advice tailored to your specific situation, feel free to reach out to us at BW Group. We’re here to help you navigate the complexities of business taxation and achieve your financial goals.
Get started with Propelio and unlock all the tools you need to succeed in real estate. Sign up now for a 14-day FREE trial: Start Free Trial
