If you are self-employed and finding yourself paying higher taxes, you may be able to save some significant cash by switching your business structure to an S-Corporation. You are likely currently reporting your business on Schedule C of your Form 1040. This will lead to costly federal employment tax (including the dreaded self-employment tax) that can be avoided with the establishment of an S-Corp.
With an S-Corp, only the W-2 wages that the corporation pays to you would suffer the federal employment taxes. Here’s how it works in a nutshell:
Essentially, the passed-through S-Corp taxable income increases the tax basis of your stock. Therefore, distributions of corporate cash flow are usually free of federal income taxes. This makes S-Corporations potentially more favorable than equivalent business structures such as sole proprietorships, single-member LLCs treated as sole proprietorships, partnerships, and multi-member LLCs that are treated as partnerships.
S-Corps can follow a very tax-smart strategy where shareholder-employees are paid modest salaries while most or all of the remaining corporate cash flow is distributed to the shareholder(s) in the form of federal-employment-tax-free distributions.
The federal self-employment tax is how the U.S. Treasury collects Social Security and Medicare taxes. For 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income. Establishing an S-Corporation can effectively eliminate this tax while providing other business advantages you won’t find with basic LLCs, sole proprietorships, independent contractors and DBAs.
Naturally, you will want to make sure you do everything right to create your S-Corp. There are several steps that will need to happen when filing documentation with your state, setting up business bank accounts, implementing a new payroll system, getting a local business license and more. It will cost some money upfront and take a little time, but the benefits are well worth it in the long run as you can avoid these federal employment taxes. You’ll never fully escape paying taxes for your business and your personal income, but there are strategies you can implement to minimize what you have to pay each year.
To learn more about how to establish an S-Corporation or another legal business entity based on your specific tax situation and business structure, contact the team at Illumination Wealth today. Let us help you optimize your tax plan and business plan.