When it comes to being self-employed, in most cases, you will have to pay more Social Security and Medicare taxes as compared to a person who is employed by a company. There is an effective way to reduce such taxes; you can do so by organizing your company as an S Corporation.
An S corporation is a type of company that fulfills the Internal Revenue Service (IRS) requirements to be taxed under Subchapter S of the Internal Revenue Code. Such an organization offers the advantage to a company that has 100 shareholders or less and is taxed as a partnership. This way, the company is not taxed at a corporate level, but at the individual level of shareholders.
Regardless of whether you are employed by some other company, or are self-employed, you will have to pay Social Security and Medicare taxes no matter what. However, when you are working for someone else, you are only partly responsible for paying the taxes – the employer also contributes by paying 50% of the taxes.
Being self-employed, however, means that you will have to pay both the portions of the tax on your own. As of 2012, the combined portions of this tax (both employee and employer) amounts to 15.3 percent.
S Corporation Distributions
If you wish to organize your business as an S Corporation, you should specify some of the income as salary, while some must be classified as a distribution. Still, you will be expected to pay self-employment taxes on the portion of your income that you have classified as your salary. On the other hand, for the distribution portion of the income, you will only be liable for ordinary taxes.
Based on how you go about dividing your income as salary and distribution, you can save quite a bit on taxes by converting your company into an S corporation.
Risks of S Corps
Even though S corporations have a lot of benefits for shareholders, especially where the payment of taxes is concerned, you need to be aware that the IRS keeps a close eye on S corporations because of the possibility of abuse.
For instance, a person may be earning an income of $500,000 a year, but they might allocate $20,000 as the salary; this kind of disclosure can trigger an IRS inquiry.
The best way to be safe and legal is to designate a reasonable amount as your salary and distribution. Being reasonable usually falls into a ‘gray’ area; you should generally try not to push the envelope too far as it could invite an IRS audit.
Additional Costs for S Corps
In some instances, an S corporation may cost you more than it saves you. Ongoing legal and accounting costs can add up. However, you can properly manage your records by properly tracking and managing your expenses using a professional accounting software such as QuickBooks, which can reduce your accounting costs.
If you keep a track on all your income and expenses, you will have a better chance of gaining maximum profit.