There are many advantages to being self-employed, but with every silver lining comes a cloud in the form of paying higher taxes under the guise of both social security and Medicaid. Collectively, these taxes are referred to as “Self-Employment” taxes. Generally speaking, these taxes are significantly higher than those one would pay if he or she were an employee. Thankfully, there is a way to reduce overall tax liabilities.
What is an S-Corporation?
What if there was a way to reduce an individual’s taxes? What if he could pay taxes at the same level he would pay if he were an employee instead of a business owner? The reality is that if an individual turns his sole-proprietorship into an S-Corp, he may be able to avoid paying higher taxes. If this sounds too good to be true, it generally isn’t because one may face a little more scrutiny from the IRS to ensure the individual is filing fully in accordance with all applicable laws, codes, and regulations.
Under the normal business structure, the business files its own tax return and pays taxes on its income. Any profits are distributed to the shareholders, where they are taxed again. However, few, if any, small businesses are split into separate entities. Most are a sole proprietorship; in which the business owner pays taxes on the amount of money he earns. Partnerships, similarly, are in many cases, no more than a collection of sole proprietorships; however, the IRS allows partnerships to be recognized as and taxed as a pass-through entity. In this case, all partners are taxed individually rather than under self-employment taxes, saving them all money.
We All Pay Taxes
No matter whether an individual is an employee or self-employed, he or she can’t get away from paying Social Security and Medicare taxes along with taxes on his or her income. As an employee, an individual shares the responsibility for taxes with his or her employer. If one is self-employed, he or she must pay the full amount. However, if an individual turns his sole-proprietorship into an S-Corp, he is legally able to split his income into two parts.
One part would become his salary, and the rest of his income would then become a distribution. As for the taxes on these amounts, for the income, he would still have to pay self-employment taxes on this amount. The distribution would be taxed at the much lower standard income tax rate, which could end up saving the individual a significant amount of money each year.
As with any changes to the way one plans to file taxes, this change does not come without its share of risks. To start with, the IRS is far more likely to scrutinize these type of filings as they see a huge potential for tax fraud and evasion by those who choose to file as an S-Corporation. A good example of what might arouse the IRS’s curiosity would be if a business earned $250,000 one year, but only claimed $20,000 of it as income. This might trigger an audit.
According to the IRS, it is up to the individual to claim a “reasonable” percentage of the total business income as personal income or wages. However, what constitutes a reasonable amount is a bit of gray area. One just needs to be aware that if he tries to push things a little too far, he may be audited by the IRS and subjected to penalties and interest on any amount the IRS deems should be taxed.
Nothing is Free
Although forming an S-Corp may save a business owner money on his self-employment taxes, he could end up spending more than he saves in some instances. There are going to be accounting and legal costs to bear, and some states also assess a number of additional fees and taxes on S-Corps. With this in mind, one needs to carefully weigh the advantages of forming this type of corporation against the disadvantages to make sure doing so yields the best advantage.