Someone once remarked, "Next to being shot at and missed,
nothing is quite so satisfying as an income tax refund."
There's no question that saving money on taxes is high on
everybody's list of financial priorities---especially self-employed business
owners.
However, unlike individuals who work as employees, business
owners actually have the "luxury" of choosing how much in taxes they pay each
year by picking one form of business entity over another---such as a sole
proprietorship, partnership, corporation, or limited liability company.
Unfortunately, the majority of business owners choose a
business entity once---usually when starting out---then keep the same entity for
the life of the business.
This isn't necessarily always the smartest thing to do.
While some companies can get away with sticking with the
same form of business entity throughout the life of the business, countless
others are just throwing money away by paying more in taxes than they have to.
For some smaller business owners, this financial
nonchalance can actually cost an extra several thousand dollars in
unnecessary---and avoidable---taxes each and every year.
If you're a business owner concerned about reducing your
tax liability, here's a way you can dodge the tax bullet by utilizing what's
known as a Subchapter S corporation:
FIRST SOME BACKGROUND:
When starting a new business most entrepreneurs focus on
simplicity: that is, the less paperwork and regulations to contend with the
better. What this means is that most new businesses start out as
"unincorporated" entities such as sole proprietorships (73%) and partnerships
(6%).
While management and administrative costs of running the
business might be easier and less expensive initially, the tax
burden---especially the self-employment tax---can be anything but.
For many business owners who wait until year-end to do
their tax planning---or who do no tax planning at all---the self-employment tax
is an unwelcome surprise---and a very large expense.
Newly self-employed individuals are shocked even more once
they realize that they're responsible for the self-employment tax all on their
own. That's because when they worked as an employee their employer was
responsible for paying one half of the self-employment tax.
SELF-EMPLOYMENT TAX PARTICULARS:
** The self-employment tax is simply a version of the same
Social Security and Medicare taxes you pay as an employee. However, instead of
paying 7.65% as you do when you're an employee, as a self-employed business
owner you have to pay double: 15.3%.
** In 2004, the Social Security portion (12.4%) is levied
on the first $87,900 of net profits. There is no limit to the Medicare portion
(2.9%).
** Self-employed individuals are also entitled to a one
half-credit of the tax.
** As an example, a self-employed individual with $100,000
in net profits in 2004 would be required to pay approximately $12,766 in
self-employment tax.
NOTE: This tax is in ADDITION to federal, state and
local taxes!
HERE'S WHAT YOU CAN DO TO SAVE MONEY ON THE
SELF-EMPLOYMENT TAX:
Incorporate and elect Subchapter S status. You can elect
Subchapter S status even if you have a pre-existing C corporation.
Operating your business as an S corporation is one of the
very few four leaf clovers still left in the tax code. The reason for this is
simple: The net income from an S corporation is NOT currently subject to the
self-employment tax.
If structured and implemented properly, an S corporation
could save you thousands of tax dollars per year. As an employee-shareholder of
your S corporation, you pay yourself wages just like you would any other
employee.
But instead of taking profits out through payroll, you take
cash distributions called nontaxable dividends.
Nontaxable dividends are called nontaxable, because they
aren't double taxed like the dividends paid to shareholders in a regular C
corporation (although beginning in 2008 most dividends will no longer be taxed).
You're still paying taxes on the net income of your S
corporation when you file your personal tax return, but the tax is federal tax
and NOT the self-employment tax.
For the sake of simplicity, if an S corporation with
$100,000 of pre-tax and salary profits pays its owner a reasonable salary of say
$50,000 and non-taxable dividends of $25,000, the tax would be $7,650.
** This is a whopping $5,116 savings in tax compared to the
$12,766 a sole proprietor would pay on profits of $100,000!
Even if you factor in additional costs such as workman's
comp insurance, incorporation costs, professional fees and incidentals, the
savings is still more than adequate.
CAVEATS:
** The key to successfully implementing this strategy is
that your salary must be REASONABLE under the circumstances surrounding your
business. It's also much better for salary justification purposes if your
business is not limited to the delivery of personal services by you.
** At personal income levels close to the Social Security
wage base ($87,900 for 2004), the benefits of using this strategy diminish.
BUT HERE'S SOME MORE GOOD NEWS:
If you happen to already own a regular C corporation and
you live in a state that has a high corporate income tax rate and a low personal
one, you'll come out ahead even more if you elect S status.
Additionally, if you have children aged 14 or older, you
can save even more taxes by giving them shares in your S corporation and having
them pay the tax at their lower tax rates.
By giving away shares you also reduce your estate tax
obligation.
So you see, there are plenty of good reasons to incorporate
and elect S status.
Just keep in mind that you should ALWAYS consult with your
tax advisor and attorney before making any important business or financial
decision.
Your financial situation is unique and the information in
this article may not be appropriate for your particular situation.
Always look before you leap.
When it comes to your business, you should make it a point
to assess the validity of your type of business structure on a yearly basis.
Incorporating is definitely not just for startups. There
are plenty of unincorporated businesses that are missing the boat when it comes
to saving money. Don't be one of them.
