Smart = S Corporation = $
S Corporations are an under-used opportunity available to most small Maine family businesses as a way to gain control over taxes. I have worked with S corporations for 20 years and strongly recommend their use for the vast majority of operating businesses.
What makes the S corporation so special? Why is it the best vehicle for saving taxes for most small businesses? What happens if you start a new business and don’t think about tax consequences?
The Story of John the Plumber
Once upon a time there was a plumber named John who worked for a large plumbing company. As an employee John received a Form W-2 from his employer each January. Because he had enough taxes taken out he always had a nice refund from the IRS.
Then one day John decided to start his own plumbing business. Because John was an honest and hard-working individual he sincerely believed that starting his own business would mean he would do well and everything would work out fine.
John ran his business for a year. The following year, not long before April 15, John went to see his accountant and provided all his receipts and business records. His accountant warned John that things would be very different now that John had his own business. John didn’t understand this because, as far as he was concerned, everything was the same. He did the same high-quality work in the same diligent manner he had always done. The only difference was that now he had his own business and was the boss. Everything else was the same.
A few weeks later John’s accountant called him and asked him to stop by. John did do. The accountant was very serious and spoke to John in a grim tone. “John” the accountant said, “I hate to say this but the fact is you owe the IRS $12,283. There is nothing I can do. I wish you had called me when you started your own business.”
“Why do I owe so much?” John asked. “I’ve always had refunds in the past.”
The accountant explained that the large tax bill occurred because John was now self-employed. John had to pay not only income taxes but also a 13.3% self-employment social security tax on his net income. When John was an employee he paid only half of this social security tax (his employer paid the other half) and it was automatically withheld from every paycheck. As an employee John never had to worry about writing a check to pay this tax because it was withheld by law from every paycheck. When John was an employee of the large plumbing company this was an invisible tax, unknown, unfelt, a mere footnote in his paystub.
But now that John worked for himself he had to pay the full amount of the social security tax, or 13.3% of business income. And because John was now self-employed, there was no employer to withhold tax from his paychecks. There were no paychecks. As a self-employed business owner John became personally responsible for this tax. And this tax was in addition to federal and Maine income taxes.
“It doesn’t make sense” John told his accountant. “It’s not fair.” ‘I’m sorry” the accountant said. “There is absolutely nothing I can do to help you at this point.”
What could John have done differently that might have saved him thousands of dollars?
Tax Savings from S Corporations
When John decided to start his own business the very first thing he should have done was see his accountant. Any competent accountant would have advised John that the best way to organize his new business would be to incorporate it as an S corporation. Since John did not see his accountant, his new business was, by default, classified as an un-incorporated business or sole proprietorship. This is how your business will be classified and taxed if you do nothing.
The tax problem with sole proprietorships is that all net business income (up to $106,800 for 2011) is hit with a 13.3% social security tax levied on self-employed business owners. This social security tax is in addition to federal and Maine income taxes. If you do nothing, if you fail to plan, then you will be charged this tax. Sorry. In prior years this tax was not 13.3% but 15.3%. Under current law, this tax will go back to its original rate of 15.3% starting in 2013 (unless Congress once again extends this old rate).
If John had planned ahead he would have had the option of incorporating his business as an S corporation.
The net income of S corporations is NOT subject to social security taxes. This is the biggest difference between sole proprietorships (what you get with no planning and no thinking ahead) and S Corporations.
However, this is not to say that an owner/operator of an S Corporation can get away with paying zero social security taxes. This is not the case. As an employee-officer of your own corporation, the IRS and courts have consistently ruled that you must pay yourself “reasonable compensation.” See Revenue Ruling 74-44 and:
The salary paid to an owner/operator of an S corporation IS subject to social security taxes. So what’s the point? How do you save money with S corporations?
The answer is that reasonable compensation, in many and even in most cases, will be significantly less than the income of the business. The difference between business income and owner/operator salary is not subject to social security taxes. This difference translates into tax savings every year.
A Simplified Example
Consider the following simplified example using current 2011 tax laws:
|Do Nothing Like John
= An Unincorporated Business
and Form An
|Net Business Income||$100,000||$100,000||-|
|Reasonable Owner/Officer Compensation||N/A||($35,000)||-|
|Deduction for 1/2 of Social Security Tax
|Income Subject to Social Security Tax||$92,350||$35,000||-|
|Social Security Tax
The S corporation produces $7,628 of tax savings by reducing social security taxes owed.
The False Promise of LLC’s
Some clients are deluded by attorneys and others into believing that LLC’s, not S corporations, will save them from taxes. False. LLC’s are generally taxed as partnerships and their net income is FULLY SUBJECT to social security taxes. Some of the few exceptions to this treatment are rental income and capital gains from sales of stock.
If you are a landlord or if your primary income derives from sales of stocks, dividends and interest income then yes, an LLC may be fine for you.
All other operating businesses are far better off as an S corporation.
I learned long, long ago that most attorneys can’t count. Beware.
For comprehensive information on why LLC's are a bad idea for most people see my in-depth article:
Act Now Before It’s Too Late: The Clock Is Ticking
A company may elect S corporation status up to 75 days later. Thus, if you have a business on January 1 you have until March 15th to elect S corporation status for that year.
However, you can elect S corporation status for a business anytime because you can incorporate anytime. Sooner is better. The longer you wait the more taxes you will pay.
Any competent attorney can help you form a corporation. I offer flat fee pricing for basic clerical assistance in forming your own corporation and electing S corporation status. I help with all required forms including waiving Maine workers compensation coverage (if this is what you want to do.)
Act now before it’s too late. Don’t end up like John the plumber. Doing nothing is the most expensive option of all.
Everything I’ve said here boils down to a single easy equation:
Smart = S Corporation = $
Make the call and take charge of your taxes.
Certified Public Accountant Master of Business Administration
43 Acme Road Suite F Brewer Main 04412
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