Business owners may choose a sole proprietorship as the form of ownership for their business because of its simplicity. While It is easier to set up a sole proprietorship, the business owner may end up paying more in taxes than if the business was organized as an S-corporation. These potential tax savings occur because the owner may be able to claim part of the profits through dividends, avoiding self-employment taxes on that money.
Employees have traditionally paid 7.65 percent of their earnings in Social Security and Medicare taxes, while their employers paid an additional 7.65 percent. Self-employed business owners operating as sole proprietorships must pay both portions, for a total of 15.3 percent, on any profits that they earn. This is officially known as self-employment tax. The employee portion of this tax was temporarily reduced to 5.65 percent in 2011; however, this reduction is scheduled to expire at the end of 2011.
Corporate Officer Employee Salary
An S-corporation is a separate entity from its owners. An S-corporation does not pay self-employment taxes but does pay the employer's portion of FICA and Medicare taxes for its employees based on their paychecks. Owners of the S-corporation who perform duties for the corporation must be paid a salary for these services pay the required FICA taxes. In addition, the S-corporation must pay the employer's tax share on the owner's salary.
Dividends and Tax Savings
S corporations can pass dividends on to their owners to claim on their personal tax returns, and pay taxes on the earnings at their own personal tax rate. Any profit amount from the S corporation left over after paying all of its expenses passes through to the owner's tax returns as a dividend. The dividends of an S corporation are not subject to self-employment taxes. This exemption of dividends can be a sizable advantage of an S corporation over a sole proprietorship.
Limitations on Dividends
The owner of an S corporation must be paid a reasonable salary for the work that he does and pay the appropriate FICA taxes on that salary. Reasonable salary depends on multiple factors, including the owner's expertise, and what other people earn in similar jobs. The IRS looks carefully at S corporations that it doesn't feel are paying sufficient salaries, and it will bring legal action against those that it feels are taking excessive distributions of dividends compared to salaries.
Example of Tax Savings
If a company set up as a sole proprietorship earns $100,000, the owner pays self-employment tax on the entire amount as well as income tax. If an S corporation earns the same amount but pays its only stockholder a $50,000-per-year salary and designates the additional $50,000 in profit a dividend, the employee-stockholder would pay 5.65 percent of his salary (in 2011), or a total of $2,825 in FICA taxes. The corporation would pay 7.65 percent, for an additional $3,825, for a total of $6,650. The dividend passes through to the owner, on which he pays income tax but avoids the self employment tax, thereby saving $6,650
- Internal Revenue Service; Wage Compensation for S Corporation Officers; August 2008
- "Entrepreneur"; Why Getting a "C" Might Be Smart Business; Bonnie Lee; July 2009;
- Bankrate; LLC vs. S Corporation; George Saenz; October 2006
- "Inc."; Should Your Business Be an LLC or an S Corp?; Darren Dahl; March 2011
- "The Tax Advisor"; S Corporation Shareholder Compensation: How Much Is Enough?; Tony Nitti; August 2011