1. Tax Savings
If your business is a partnership or a sole proprietorship, and your business is very profitable, you are paying both self employment tax and income tax on those profits. Self employment tax, unless you have already maxed out on FICA, is around 14% (after adjustments).
If you are organized as an S-Corp, you can pay yourself a payroll check and your payroll check is deductible by the business.
Tammy is an IT consultant with net income from her LLC of around $250,000. She decided to become an S-Corp on the advice of her tax professional. She is required, as the sole proprietor and full-time worker for her S-Corp, to pay herself a reasonable salary. She determines that she should be paid a salary of $100,000.
Here are the taxes she would pay as a sole proprietor versus an S-Corp, assuming in both examples that Tammy files as single and takes the standard deduction:
|Sole Prop (Schedule C)||S-Corporation|
|Net Business Income||$200,000||$91,930|
|Payroll Taxes (FICA, Med, FUTA)||N/A||$15,720|
|Self Employment Tax||$20,050||N/A|
|Total Tax Paid||$63,382||$58,993|
Tax Savings of $4,389
2. Perception of Lower Taxes
The tax savings noted above are significant but it might feel as if the tax burden of the owner(s) of the business is less as an S-Corp, because the payroll taxes and withholdings are paid by the company, not the individual. In our example, Tammy pays $43,879 in income tax, part of which would have been withheld from her paycheck and her S-Corp pays all the payroll taxes and withholdings for her. So it might feel like she has a much greater tax savings than calculated above.
3. Better Cash Flow For Seasonal Businesses
If you are a seasonal business, it may be difficult to make your quarterly payments at certain times of the year, such as immediately prior to your busy season. As an S-Corp, your quarterly payments can be reduced significantly and you can stop your paychecks during the low season if cash flow is not there, and make up for it when you do have more cash. As a Schedule C business, you would be locked into the quarterly payment schedule no matter what. (I realize you can get around this by paying quarterly payments early when you do have cash.)
4. Reduced Audit Risk
The audit rate for Schedule C businesses is 2.9%, and the audit of S-Corps is 0.5%. This could change, but by making this move, you are significantly reducing the likelihood that you will be audited. This is helpful not because you want to take advantage but because audits take time and money that you probably don’t have to give.
5. Ease of Growth, Ownership Transfer, and Sale
As an S-Corp, ownership is represented by shares of stock. If you are in a 2-person 50/50 partnership and your partner sells their interest to another person, the partnership is technically terminated. As an S-Corp, this would not be the case. In fact, you could sell all your shares to an acquiring company and they could continue to operate it as the same S-Corp with different owners. If sale of an S-Corp is accomplished through sale of stock, the gain on sale for the shareholders is considered a capital gain, rather than selling assets of a partnership which generates some ordinary gains as well.