First off for clarification, as most don’t know the difference, an S-Corporation is not always a corporation. An S-Corporation is strictly just a tax entity, whereas an LLC or Corporation are legal entities. However, in order to be taxed as an S-Corporation, you will need to first be set up as either an LLC or Corporation with your State, and then elect to be taxed as a subchapter S corporation.
So, the way an S-Corporation saves tax is that it allows business owners to avoid Social Security (12.4%) and Medicare tax (2.9%), better known as self-employment tax (15.3%), on a portion of the business profits.
For example, a small business earns a net profit of $100,000. As a sole proprietor or partnership, you will pay about 15.3% in self-employment taxes on your full profit of $100,000. The calculation is a little complicated to come to the exact amount, however self-employment tax is roughly 15%. So, you will pay about $15,000 in self-employment tax on $100,000 of net profit as a sole proprietor or partnership.
As an S-corporation, you get to split your net profit into 2 separate categories; “Shareholder’s wages”, and “Distributions”. Shareholder’s wages are the only category that is subject to the self-employment tax of 15.3%. So, for example, the $100,000 of net profit can be split into $50,000 of wages and $50,000 of distributions. The wages of $50,000 will be subject to the 15.3% self-employment tax, whereas the $50,000 of distributions will not be subject to the 15.3%.
Therefore, in this case, as an S-Corporation with $100,000 net profit and $50,000 in wages, you will pay about $7,500 of self-employment tax. The remaining $50,000 of profit will be considered distributions not subject to the self-employment tax. You will be savings about $7,500 in tax as an S-Corporation compared to a sole proprietor or partnership.
There are a lot of additional factors to consider when switching over to an S-Corporation. For example, payroll, legal requirements with the State, tax preparations, and some additional tax law differences. However, S-Corporations were created to save tax by avoiding social security and Medicare tax on a portion of your business profits.
Anthony Fontana EA