If you are setting up a business entity, there are a number of considerations to be weighed. One, of course, is taxes. More specifically—tax savings! Your business entity should not only protect your personal assets from liability, but it should also make, or save, you money.
Benefits of an S-Corporation
In an S-corporation, there are no corporate taxes. Instead, you pay income tax on all “pass-through” corporate profits no matter how you take them out of the business. So it may appear, on the surface, that it doesn’t matter whether you pay yourself a big salary or big dividends. Until you consider the “payroll tax” difference.
Dividends paid out by an S-corporation are not subject to Social Security tax or Medicare tax (a savings of approximately 15.3%). This can result in significant savings with careful planning and the help of your CPA (every business entity should employ an experienced CPA).
In order to produce these savings, the stockholder/employee must reduce their salary. Sounds backward, I know. But the concept is to lower your salary to a “reasonable compensation” and then pay yourself the rest in dividends. “Reasonable compensation” is that amount which another company might pay you for your services given your qualifications, experience and the nature of the work. Frankly, your real value to the corporation is probably your entrepreneurial skill rather than your day to day services. So, paying yourself substantial dividends shouldn’t be a problem. Again, your CPA can help you with this calculation.
Here’s an example of how this strategy can work: an electrician/shareholder expects to earn $160,000 net this year. The electrician reduces his salary to $113,700 (the maximum Social Security benefit) and receives the remaining $46,300 in dividends. This creates a savings of approximately $7,083.90.
If this electrician had little confidence in the Social Security system and didn’t want to pay out as much payroll tax, for the maximum benefit later, his tax savings would increase as his dividends go up.
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The type of tax saving described here is only available in a Sub-S (small) corporation and it is often overlooked. For more ideas about how to make and save money in your business entity, simply call our office for an appointment.