How an S Corp Can Save You on Self-Employment Taxes

If you're running an unincorporated small business, you probably don't like the size of your self-employment (SE) taxes. No wonder!

In 2023, the SE tax hits hard at a whopping 15.3% rate on the first $160,200 of your net SE income. That includes 12.4% for Social Security tax and 2.9% for Medicare tax. The Social Security tax ceiling has increased to $160,200 from $147,000 in 2022, and it's only going to get worse in the future due to inflation. Beyond the Social Security tax ceiling, the Medicare tax keeps going at a 2.9% rate before jumping to 3.8% for higher levels of net SE income, thanks to the additional 0.9% Medicare tax on all income.

The S Corp Advantage

For the wages you pay yourself as an employee of an S corporation in 2023, the FICA tax withholding rate is 7.65% on the first $160,200 of wages. This breaks down to 6.2% for Social Security tax and 1.45% for Medicare tax. Once you exceed $160,200, the FICA tax withholding rate drops to 1.45% because the Social Security tax no longer applies. However, the 1.45% Medicare tax still applies to your wages, regardless of how much you earn. At higher compensation levels, the rate increases to 2.35% due to the additional 0.9% Medicare tax.

While an S corporation employer matches the payments, except for the additional 0.9% Medicare tax which is solely the employee's responsibility, the combined FICA tax rate for Social Security tax is 12.4%, and the combined rate for Medicare tax is 2.9%, increasing to 3.8% for higher compensation levels. These rates are the same as the corresponding SE tax rates.

Strategy: Become an S Corp

When you pay wages to yourself as a shareholder-employee of an S corporation, those wages are subject to federal employment taxes. However, any remaining taxable income that passes through to you as the employee-shareholder is exempt from federal employment taxes. The same goes for cash distributions paid to you as a shareholder-employee. Since passed-through taxable income from an S corporation increases your tax basis as a shareholder-employee, distributions of corporate cash flow are usually not subject to federal income tax.

In certain cases, an S corporation can adopt a tax-saving approach by paying reasonable salaries to shareholder-employees and then distributing most or all of the remaining corporate cash flow to them as federal employment tax-free shareholder distributions. On the other hand, the owner's share of net taxable income from a sole proprietorship, partnership, or LLC (treated as a partnership for tax purposes) is generally subject to the full impact of the SE tax.

There is a potential downside, though.

Operating your business as an S corporation and paying modest salaries to shareholder-employees may limit your ability to contribute tax-deductible amounts to retirement accounts. For instance, if an S corporation has a SEP, the maximum annual deductible contribution for a shareholder-employee is capped at 25% of their salary. So, the lower the salary, the lower the maximum contribution. However, if the S corporation establishes a 401(k) plan, paying modest salaries typically won't hinder substantial contributions.

Converting an unincorporated business into an S corporation has other legal and tax implications. It's a big decision, and we're here to guide you through all the details.

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