You have been operating your business as a sole proprietor for several years. Now, as the business is growing, you are thinking about incorporating as an S corporation in order to limit your liability, avoid double taxation of corporate profits, and to make it easier to obtain financing. Your accountant suggests another advantage to consider: reduction of your liability for employment taxes. Intrigued, you ask for more information.
Shareholders can wear two heads—employee and investor
Reducing your overall employment tax liability is possible because you can be both the owner and an employee of your corporation. Shareholders can be employees of the business—this means that they can be paid salaries as employees. Employment taxes must be paid on the amounts received as salary. However, shareholders can also receive dividends from the corporation. No employment taxes need to be paid on a dividend.
Putting these two options together means that a reasonable characterization of money received as salary versus dividends can help you reduce self-employment tax liability, while still generating business expense and wages paid deductions for the corporation.
Comparison of tax liability demonstrates savings
You think that dividing your income from the business into salary and dividends sounds promising, in theory. But, you still want your accountant to show you the dollars.
Your business will have $200,000 of gross income in 2011. Your deductions total $100,000, leaving $100,000 of income that you will receive. How does having a corporation and taking $100,000 partially as salary and partially as dividends save you money?
- Sole proprietorship. You must report the entire $100,000 as earnings from self-employment as income on your Form 1040. You must also pay self-employment tax on these earnings, which will be $12,283. (You are entitled to deduct one-half of this payment from your gross income.)
- Corporation. You elect to receive a $20,000 dividend and $80,000 in salary. The total employment tax liability is $10,640. (Although your corporation receives a deduction for the employment taxes it pays.) Using the dividend/salary strategy saves you over $1,600 in employment tax liability in 2011, alone.