This lowering of SE taxes may not really be the best reason to incorporate but often it’s the most visible tax benefit
This question arises during tax filing season usually from clients that have an established schedule C or sole-proprietor type business and get hit with high self-employment (SE) tax in addition to regular income taxes. SE tax can be a significant annual expense for many small business owners especially if their business is growing and needs more capital in the business to fund things like advertising and customer retention. Paying SE taxes of course increases one’s social security benefits far in the future but can be at the cost of capital available to fund a growing small business when it is needed today if one’s budget is tight. This lowering of SE taxes may not really be the best reason to incorporate but often it’s the most visible tax benefit and fortunately can still be a viable strategy for small and growing businesses that generate significant revenue independent of the owner’s labor.
Often there are good legal reasons to incorporate as well, such as for personal asset protection or maybe your industry has regulatory concerns that make a sole proprietor type business too risky indeed. I’ll address mostly the S-Corp form in this article since that is most often chosen by small growing taxpayers for the potential SE tax relief. If your business however has multiple owners, outside investors, or different compensation needs of owners, this adds a lot of complexity to this discussion which might then look at the C-Corp or LLC form of business for example rather than the S-Corp which is a little more restrictive in this regard.
Frequent legal issues to consider when incorporating your small business include state licensure of the corporation for certain professions or contractors and possibly having to form a professional corporation if required in your state, obtaining your business legal name and hopefully trademarks, transferring your dbas, setting up new banks accounts, transferring titles if you contribute registered assets such as trucks to the business, obtaining proper insurance, etc. are some of the many common administrative chores encountered.
Actually incorporating your business however is all too easy these days with many resources available on the internet to file the requisite legal documents such as articles of incorporation and the initial list of directors (usually the taxpayer) with your state to achieve formal corporate recognition. Often the most difficult thing is obtaining the tax ID numbers, filing the S-Corp election (important!), changing your business name with customers and vendors, establishing a new bank and merchant account and informing all your counterparties about the new name or tax ID number, but this is the sort of stuff that your CPA can help you with.
Filing an S-Corp election allows the corporate income to be taxed on their individual tax return similar to a partnership interest. This is often the source of significant tax savings since there is no separate Federal income tax on the corporation income unlike a traditional or C type corporation which is the alternative to an S-Corp. The C type corporation however is taxed quite differently but can also have merit for larger or more established businesses so you should consult your own CPA about that subject if you are interested. Be aware that there is a time limit each year to request S-Corp status from IRS so do not miss the filing deadline of form 2553 if you decide to incorporate and make this election.
Back to saving taxes, one should be aware becoming an S-Corp merely to lower one’s SE tax has however become increasingly restricted by IRS. The earnings from an S-Corp report on Schedule E to the taxpayers return and this income is not automatically subject to self- employment (SE) tax like income on Schedule C or partnership income so IRS sometimes scrutinizes this area and just how much of the S-Corp earnings is subject to SE can be a complicated determination. The ratio technically depends upon how much of the taxpayer’s income is from personal services of the taxpayer versus efforts of employees for example or sources independent of the owner. Sometimes this is a point of contention in audits to prove how much physical time the owner spends generating income in the business which is what the SE tax actually should apply to. So S-Corps are really more ideally suited to investors than owner/operators since this flow thru of income to hopefully a lower individual tax rate does provide tax benefits by reducing double taxation of corporate income but not always for SE tax which is what small business taxpayers are trying to avoid. Most of the time however the taxpayer is both an investor and operator which makes this a confusing area for sure.
Because of this perceived loophole and its actual complexity in practice, the IRS requires your S-Corp to pay you a reasonable salary that is subject to social security tax so if you are working in the business or otherwise spending substantial time effort to manage or run the business rather than being a mere investor, this rule would certainly apply. This wage requirement works opposite of any strategy to lower SE tax which was one of the main draws for S-Corps in years past but there is still some leeway in practice today. Small S-Corps that diligently report their payroll taxes each month and heed the warning to pay the owner a salary, even a low amount if justifiable, generally do not attract a lot of IRS attention. Those that get too aggressive by paying no owner salary when they are reporting a profit often get IRS attention, really what you want to avoid since this is difficult to respond to.
In practice “reasonable salary” is vague and a small but growing business can often justify lower salary levels for the owner which increases the corporation’s net pass-through income. The argument that the company is attempting to retain capital to grow is often true and can generally get a pass with reasonable IRS agents if you get audited on this point. The owner can also withdraw retained earnings from the S-Corp as distributions which are similar to dividends except since this money was already taxed on the shareholders returns it is not subject to double taxation unlike dividends paid from C-corps, large companies or mutual funds. This is one of the key features of the S-Corp for the small growing business and in this way the taxpayer can maintain a lifestyle and pay their income taxes or other needs via distributions of the earnings in lieu of a large salary while hopefully growing their business.
This strategy of reducing SE taxes has limited benefits for very small businesses but can often save up to $12k in SE taxes annually if your business usually nets over $120k which is internal capital many small business could certainly use to grow, a nice addition to their advertising budget perhaps to keep sales growing. That may be why the IRS cuts this area a little slack in my estimation, certainly a grey area within the tax law… what else is new? The taxpayer can minimize audit risks by paying the owner “reasonable” salary levels. Your own tax preparer can probably help illustrate the above benefits and recommend a salary level that would likely avoid triggering an audit.
Once your S-Corp has hopefully grown from all your hard work and has recurring and stable income levels, I recommend the taxpayer pay themselves a larger salary in order to not starve their social security account which may be a viable source of future retirement benefits and because often banks need to see larger W2 amounts in order to qualify for loans. Also I think having a larger W2 makes one feel more powerful and is the sort of status symbol showing you have an abundant mindset so keep that mental picture as your eventual goal here when you strike it rich and just pay the social security tax already like the rest of us do. Think of this strategy as something to consider in the early growth phase of your business and not something you would continue once your business hopefully becomes successful.
Another often overlooked benefit of incorporating, especially established businesses with greater than $1 million in annual sales is reduction in the frequency of IRS audits. This applies also to smaller schedule C filers as well as they also have higher audit incidence. Historically the larger schedule C businesses are by far the favorite target of IRS audits with almost 8% of large schedule C filers getting audits while the S-Corp’s have audit rates of less than 1%. This is true because schedule C produces both income tax and SE tax when expenses are denied in an audit so the IRS obtains far more revenue per audit hour in this area but also because many tax filers do not use a professional tax preparer. Most people bothering to incorporate on the other hand recognize the benefit of hiring a CPA or other tax pro so the returns they file look more proper and reasonable and are much less likely to get audited to begin with. Sometimes if one is lucky, the IRS inquiry is just regarding some expense line items and you can mail in a response but often the IRS wants the taxpayer (or your representative) to appear in the IRS office which is time consuming and often unpleasant.
The mere reduction of the frequency of audits is actually in my opinion one of the best reasons for becoming an S-Corp. Anyone that has undergone a difficult IRS audit knows how time consuming, invasive and stressful it can be having a government agent going through your business records not to mention the bill I need to send my client for all my time and of course on top of that any related tax assessment issued. In the event you receive an audit notice, your best option however is still to have your tax pro represent you which usually reduces your stress, restricts access to you the taxpayer and delays the audit process giving you time to react to any unexpected IRS questions and make reasonable responses. This is what your tax pro is really there for to be your representative when confronted by IRS or your state tax agency so you should be sure they are up to this task and have this sort of negotiating experience.
So if you decide to go ahead and incorporate, congratulations but be sure to involve your tax preparer in the matter early on and certainly consider filing the S-Corp election as there are deadlines to doing so and your preparer can be sure you otherwise qualify. Additionally, the corporation has to file its own tax returns and often pay a small corporate tax to its domicile state (it’s actually up to $800 in California as a minimum tax nowadays just for the privilege of doing business) so there are compliance costs to consider which you should also discuss to see how they might offset the potential overall benefits. Because of the compliance costs, it often makes sense to time incorporating with the calendar year in order to get the most bang for your buck in terms of first year tax benefits.
Also inquire with your tax preparer their estimated cost of tax compliance such as filing returns and any accounting necessary, often your preparer will offer a discounted rate when doing both returns together. Many preparers also have wholesale agreements with online payroll and ledger software and might cut you a deal on access to their online systems which will save you money since you will need to have basic accounting records for a corporation including ledgers, journals and statements along with payroll tax reports.
Those are just a couple of the practical tax benefits, problems and unforeseen costs that I see in practice and would affect the decision to incorporate your small business or become an S-Corp. Volumes have been written about this subject but in practical terms S-Corp’s have been a mainstay of small business taxation in the USA since the early 1980’s. Hopefully you are now slightly more informed on the subject (despite my convoluted efforts at writing about it!) and now have more reasonable expectations when making this important decision.
Todd Conrow CPA, SoCal Native, Father, Diver, Survivor!
