Many entrepreneurs and small business owners start out as limited liability companies (LLCs) because of the ease of formation and liability protection. With a single member, tax filing is easy – just fill out Schedule C on your tax return with your income and expenses. But as your business grows, electing S-corporation status can save you on taxes.
How Can an S-Corporation Election Save You Money on Taxes?
When you file as a sole proprietor on Schedule C, you pay income tax on the net income of your business, which is fair enough. But you also pay a 15.3% self-employment tax, or SE tax, on that net income. SE tax is the equivalent of the payroll taxes paid by employers and employees when you get a paycheck. But when you elect S-corporation status, only a part of your business income is subject to SE tax. Your cash distributions will go into two buckets: tax-free distributions and a salary paid by your S-corporation. Net income from the S-corporation is still taxed on your personal return, but your salary is the only piece of that net income that’s subject to SE tax, which means you’ll save on taxes.
What is a Reasonable W2 Wage for an S-Corporation Owner?
Now, it’s tempting to set the salary low, say at $20,000, and distribute $150,000 in cash. IRS rules state that your salary must be reasonable, which is a very grey area. A good rule of thumb is to set your salary similar to what similar enterprises would pay for the same type of work. To keep it simple some accountants suggest using the 60/40 rule, which is to pay 60% of your income as W-2 wages and the remaining 40% as distributions.
What Happens if the IRS Determines My W2 Wage Was Too Low?
Low or no salary is a red flag for the IRS and increases your chance of an audit. The IRS may reclassify your distributions as salary if they think your salary is too low which means you will owe SE taxes plus penalties and interest.
Not all businesses will qualify for S-Corp status though. You can click here for details on the requirements for the S-Corp election as well as the business and payroll filing requirements.
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