I briefly discussed LLCs, S Corporations, and C Corporations in a previous article.  In this article, I’ll expound more on S Corps, their basic operating principles, and demonstrate potential tax savings.

The Inception of an S Corporation

S Corps are an interesting phenomenon.  They can’t just be created out of thin air (filing some documents) like an LLC or C Corp.  It’s more of a tax status election which changes an LLC or C Corp (I’ll just refer to LLCs from here on out).  So, why would someone want to have their business taxed as an S Corp?  An S Corp has potential tax savings, that’s why! The explanations for S Corps can be found on the internet, and most of them (probably copied from one another), give general information on how S Corps work.  These articles are very superficial, and they make it seem so easy that you could strike out on your own and create one.  You probably could!  According to those articles (and it’s true), all you need to do is create an LLC, file Form 2553 with the IRS, and you have yourself an S Corp!  You then just need to pay yourself a “reasonable wage”.  That’s where all the other articles end.  Well, what does it mean to pay yourself a reasonable wage?  How much is considered reasonable? Can you just give yourself X% and call it good?  Let me address these points in turn.

Reasonable Wage

A number or formula for reasonable wage isn’t defined by the IRS.  Here’s a list of general considerations the IRS has released from https://www.irs.gov/pub/irs-news/fs-08-25.pdf:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

It’s up to the owner of an S Corp to figure out what a reasonable wage is for their line of business.  Of note is that medical premium payments can be considered as part of your wages, which could further lower the actual cash wages received.  Some S Corp specialty groups recommend using a 30% wage as a starting point for figuring out compensation.  If you’re an online ESL teacher, maybe you’re thinking that 30% might be too low.  Well, what is it that you actually do?  Have you listed your duties and responsibilities?  How much do you advertise yourself?  Do you have to update and manage a teaching platform, or is most of that done for you by a company you contract for?  Do you thoroughly prepare for class or do you wing-it and follow teacher tips?  Do you create the teaching material, or is it provided for you?  These are the types of things that you would want to consider when justifying your reasonable wage.  Maybe that “ESL Teacher” title lends itself better to “ESL Facilitator” or “ESL Guide”.  (Hopefully you don’t perceive me as trying to knock the online ESL profession!  I’m only trying to provide an example of how to justify and reason for lower wages, and thus, in turn, lower taxes.)

Now that you’ve decided to pay yourself a reasonable wage (I’ll use 30% as an example), how do you actually pay yourself that wage?  Well, let’s say you’ve filed an LLC, filed Form 2553, and applied for and received an EIN (can be done online with the IRS).  An EIN is necessary for an S Corp because the S Corp will actually be hiring the owner and thereby turning them into a W2 employee.  If any of you have been a W2 employee, you know that you turn in your hours, get paid for them, and that your paychecks have taxes taken out for you.  You will now be doing that for yourself (aaaaah!—That was at least my first thought).  The good news is that you can run and pay payroll taxes for yourself quarterly, as long as your tax liabilities are less than $2,500 during the year.  I discussed a bit about payroll in my previous article on LLCs and Fringe Benefits.

To pay payroll taxes, you can do so fairly easily by creating an EFTPS.gov business account and file Form 941 quarterly payroll.  This only takes care of your federal tax liabilities though.  States typically also require you to withhold and pay payroll taxes and unemployment.  You would need to ensure that you obtain a withholding number from your state so you are able to pay these.

If you’re thinking, “Wait… what happens to the 70% of business income that isn’t assigned as wages?”, then that’s a great question!  That extra 70% is allowed to be taken as a distribution which isn’t subject to self-employment taxes.  It is only a subject to income tax (so if you’re an expat that gets to exclude income tax, you’re in a prime position for even more tax savings!).  Distributions are another commonly erroneously discussed topic on the internet when it comes to S Corps.  If you invested $10,000 into starting up a business, the business is allowed to pay you back that $10,000 tax-free.  This is a distribution that affects your basis (how much you invested in something).  If you didn’t invest money into starting up your business, you can still be given a distribution.  It is subject to income tax at this point.  I’m glad we cleared that up.  Onward!

Calculating Savings of an S Corp vs Self-employment

Now that we have discussed the more well-rounded picture of S Corps, let’s use some example numbers to demonstrate actual potential savings.  For this example, we will use a single taxpayer which means they have a $12,200 standard deduction (that much can be excluded from income tax).

Self-employment (SE)

Earnings: $20,000

SE tax: $2,826 ($20,000*0.9235*0.153)

Income tax: $639 (($20,000-$12,200-0.5*$2,826)*0.1 [10% tax bracket])

Total tax: $3,465

S Corp (30% wages)

Earnings: $20,000

FICA (SE tax equivalent): $918 ($20,000*0.3*0.153)

Federal and State unemployment: $198 ($20,000*0.3*0.033 [2.7% for state, 0.6% for federal])

Income tax: $714 (($20,000-$12,200-0.5*$918-$198)*0.1 [10% tax bracket])

Total tax: $1,632

(Total tax for expats: $1,278—if qualified for the foreign earned income exclusion).

S Corp savings compared to self-employment: $1,833

Calculation Explanations (You can skip this if you want… I probably would!)

A brief explanation of the above calculations.  SE tax is only taxed on 92.35% of your net income, then you apply the standard SE tax rate of 15.3%.  Income tax takes your earnings and subtracts your standard deduction.  Then, you’re allowed a ½ deduction of self-employment tax against your income.  What’s left over falls in the 10% income tax bracket.  For the S Corp scenario, your business earnings are $20,000, but you’ve decided on a 30% salary/wage of the business earnings.  Then, the FICA rate of 15.3%.  For federal and state unemployment, many states start out a business at 2.7% which means you get a credit for federal unemployment and only have to pay 0.6% for that.  Income tax takes the total earnings of the business, subtracts the standard deduction, subtracts the employer’s half of FICA (which would be a business income deduction), subtract the full unemployment expenses, and what remains is in the 10% income tax bracket.

Recapping

An S Corp comes into being by filing Form 2553 with the IRS.  It is filed after creating an LLC or C Corp.  You will want to get an EIN so that you can run payroll and pay yourself that reasonable wage you justified and decided on.  You can create an EFTPS.gov account to pay payroll taxes online (you could always sign up for a monthly subscription service to file and pay your payroll taxes for you, but those can cost around $500+/year.  If you pay an independent payroll service to do it for you, there is also a potential of theft of funds by the company, and you’re left on the hook with the IRS!).  Make sure you grab a withholdings account with your state and find out what unemployment taxes you may need to pay.  If this still seems like a lot and a bit overwhelming, don’t worry!  There are plenty of tax and accounting professionals out there, myself included, that can help make sure you’re on the right track.  You can also reread this article and read related articles to help solidify your understanding of the process.  An S Corp is a great way to save on self-employment taxes and gives you a greater sense of the business world!