You started a small business. You were told, “You need to be an S Corporation so your taxes will be lower.” You didn’t know what that meant, but it sounded like good advice so you paid someone to file all the right paperwork and now you have an S Corporation. Now you’re paying less taxes, right? Right??
The premise behind the tax savings of an S Corporation is that taxable profits from S Corporations aren’t subject to self-employment taxes while the profit from a proprietorship, single-owner LLC, or a partnership often are. Even with the requirement that S Corporation owners working for the business generally take a salary from it (and thereby pay in some level of self-employment taxes via Social Security and Medicare withholdings), the self-employment tax savings to operating as an S Corporation could be thousands of dollars annually. This still seems like a no-brainer, doesn’t it?
Here are situations in which an S Corporation doesn’t save money:
- The business’ sole activity is real estate rentals. Rental income typically isn’t subject to self-employment taxes in the first place. On the other hand, the IRS still expects S Corporation owners to receive a reasonable salary from the business. This circumstance is what tax advisors call a “bad answer” – an activity that didn’t generate self-employment tax to begin with now does due to owner salaries.
- New businesses often operate at a loss. No income means no self-employment taxes. In the meantime, though, there could still be an expectation that the owner receive a salary. Again, a bad answer. Rather than starting off life as an S Corporation, the business could instead start out in another form that doesn’t involve an owner salary and then later establish S Corporation status when the level of business profits is high enough to generate tax savings.
- Even when profitable, new businesses often have lower profitability than later in the business lifecycle. For these businesses – particularly those with a sole owner – the self-employment tax savings of an S Corporation may be less than the costs of administering the S Corporation.
- Business partners are sharing business profits based on revenue production or other method not aligned with ownership percentages. In this scenario, the ownership group is likely ‘truing up’ profits via increasing owner salaries which results in most or all of the profits being subject to self-employment taxes through Social Security and Medicare withholdings.
- Under the Tax Cuts and Jobs Act effective 2018, the intersection of S Corporation owner salaries and the 20% Qualified Business Income deduction calculation can yield unfavorable results. For some taxpayers, the income tax savings lost due to operating as an S Corporation is more than the self-employment tax savings of operating as an S Corporation.
Every situation is unique! Please contact us if you have questions about whether an S Corporation is a helpful tax reduction strategy for your situation.