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, it should also make, or save, you money.
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 stock holder/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. 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.
This type of tax saving 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.