The 3 Best S-Corp Entity Structures for Tax Savings

Why You Need to Structure your Entities Correctly

 

If you’re self-employed or a partner in a partnership, you already know that taxes have a lot to do with your entity structure.  Getting your entity right is a set-it-and-forget-it move that can save you thousands in taxes every year.  However, doing it incorrectly can cost you big time in taxes, and stress.  So you need to get it right, and this article will help you with it.

 

 

Entities in General – What’s the Right Answer

 

There are lots of ways to structure a business.  These are the most common entity types for tax purposes:

  • Disregarded Entity

  • S-Corporation

  • C-Corporation

  • Partnership

And you can have different combinations of these entities too, if you have more than one. So… what’s the best entity?  And what’s the best structure? Of course, the answer depends.

 

However, for many self-employed individuals and business owners, the S-corporation will play a role in how you set up your entities.  But first, what is an S-corporation, and how can it actually save you in taxes?

 

What is an S-Corporation

 

In a nutshell, S-corps are entities that don’t pay tax.. They file “information tax returns” annually on Form 1120S.  The profits flow through to the owner(s) via K-1, and the income is considered ordinary.

 

S-Corporations can save you in taxes because they change the type of income that you’re earning.  What do I mean?

 

How Self-Employed and Partnerships Pay Taxes Normally

 

When you make self-employment net income more than $400, you must file a Schedule C.  Net income on Schedule C is considered earned income, and earned income incurs two taxes:

1) income taxes – at your highest tax rate

2) payroll taxes – FICA taxes of 15.3% (aka, the Self-Employment tax)

 

So if you’re in the 24% tax bracket, then all the profits that you make from self-employment are taxed at 39.3% = (24% + 15.3%).  That’s almost half of everything that you make.  No bueno.

 

The same goes for general or active partners in a partnership.  All profits are considered earned income, and they are taxed in the same way.

The way to reverse this is to use the S-Corporation.

 

How S-Corporations Create Tax Savings

 

S-Corp profits are not considered earned income.  Therefore, they don’t get the self-employment tax.  That means that profits from an S-Corp are taxed 15.3% lower than profits from self-employment or partnership income. 

 

So for example, if you had 100K in self-employment or partnership profits in the 24% tax bracket, then you’d pay close to 40K in taxes on it. 

 

However, if those profits were from an S-Corporation, then they’d be taxed at only your ordinary tax rate, since they’re not considered earned income.  Therefore, the taxes on those would be $24,000.  The net savings in this case would be $15,300.  And this would happen every year.  Big savings.  But there’s a catch.

 

You have to pay yourself a “reasonable salary” via W2 when you own an S-Corporation.  And the salary that you pay yourself is considered earned income.  And that portion gets the self-employment tax.

 

So if your goal is to reduce taxes now, then the game with S-Corporations is to pay yourself the lowest reasonable salary that you can, so you can minimize the self-employment tax.

 

Now you just need to structure it correctly.

 

Our 3 Favorite Structures for S-Corporations

 

As with any entity structuring decision, always be sure to consult with a tax advisor before doing anything. 

At Sussman.cpa, there are three main types of S-corporation structures that we like to use:

First, if you’re the sole owner of your business and generating a high amount of earned income, we would generally recommend to set up an LLC and elect to have it taxed as an S-Corporation by filing form 2553.

 

Second, if you’re in a partnership and profits and expenses are divided evenly, then we often recommend to simply convert the partnership to an S-Corporation.  This is commonly done with husband/wife partnerships.  However, there are many situations where we would not recommend this strategy, such as with real estate holding companies.

 

Third, if you’re in a partnership with limited partners or with unique rules with profits, losses, and capital, then we’d generally recommend maintaining the partnership as it is, but setting up an S-Corporation for each of the general partners in the partnership.  This in essence makes the profits from the partnership flow to an S-Corporation instead of the partner directly, giving the opportunity for savings on self-employment taxes.

 

 

How Do I Actually Do This – What Now?

 

We’ve now gone over three ways to use S-Corporations to create tax savings. 

 

To execute on this, you’ll want to carefully review your current entity structure, evaluate how much savings an S-Corporation can generate for you each year, and file the appropriate forms to elect S-Corporation status if the numbers make sense.

 

You should always do this with a tax advisor to ensure that you don’t make any costly mistakes and maximize your tax savings.

 

And if you’re looking for help with choosing and using the best entity structure for your business, then feel free to book a consultation with us here, and we’ll put you in touch with a CPA who can help you make a great decision in this sensitive matter.

 

We hope that you found this helpful, and I thank you for reading this.

 

Stay Smart,

 

Jonathan Sussman CPA

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