If you’re an entrepreneur, freelancer, or business owner, you’ve probably heard about the many benefits of incorporating your business. In many states, you can receive significant legal benefits by incorporating, but did you know that there can also be significant tax savings to be gained by incorporating as well? In this article, I’m going to explain one such tax advantage, and specifically how to go about doing it.
Warren Buffett, the billionaire investor is famous for his unique perspective, business acumen, and quotable quotes. But did you know he also has another famous quirk about him? Even though his company made over $24 billion in profits in 2016, Buffett only paid himself a salary of $100,000. In fact, he has been doing that for over twenty years.
While Buffett’s policy is interesting and commendable, it also illustrates that business owners can earn money in several different ways from a tax perspective. While the average person is typically simply paid an hourly wage or a salary that gets reported on a W-2 form, business owners often also make money in the form of business profits, capital gains, interest, dividends, royalties, and other ways, in addition to whatever salary they decide to pay themselves. In this article, I’m going to focus on how separating business profits from salary can save you big on taxes.
Who Can Save in Taxes by Incorporating
The tax advantages to incorporating your business are available to many people as long as they have some form of self-employment, freelance, or entrepreneurial income. In fact, this little-known tax tip can save thousands in taxes each year for anyone making a moderately high income from some form of self-employment. This could be a realtor, writer, small businessperson, or anyone who is not paid a traditional W-2 income. If you receive a 1099 form at the end of the year, you’re probably eligible. I’ve even known a few full-time Uber drivers to use this strategy!
It has become so popular lately that Congress has even looked into discouraging folks from using it, for fear of missing out on potential tax revenue. A recent Forbes.com article put it this way:
One topic, however, is a persistent concern for the government in terms of lost revenue from S Corps – employment tax. The concern is that S Corp owners can low ball their own wages, and thereby avoid paying FICA and Medicare taxes on their incomes. Some politicians have gone so far as to call S Corp status a “tax shelter.” –Steve Parrish, Forbes.com
However, no such reform has yet been accomplished by Congress, and as of this writing, this strategy is still completely legal.
How Income is Taxed for FICA, Self-Employment Tax, and Regular Income Tax
All traditional forms of “earned income” are subject to an additional form of taxation known as FICA (primarily Social Security and Medicare taxes), which is a whopping 15.3% of your income. This is on top of the regular income tax you pay to the Federal government; it is a separate tax intended to fund the costs of these social programs. Employees only pay one side of the cost, or 7.65%, because by law the employer must pay the other side of it.
Self-employed people also have to pay this tax, but it’s referred to as “self-employment tax” in this context. It is the same 15.3% rate and hits your tax return at the end of the year on top of the regular tax you have to pay. The main difference between self-employed folks and a salaried employee is that the self-employed have to pay both sides of the tax (i.e. the full 15.3%). This is why many new entrepreneurs and freelancers are shocked at the end of their first year of making real money. Their total tax bill is much higher than they anticipated because of this additional 15.3% tax.
How Separating Salary from Profits Can Lower Your Taxes
So, what can you do?
Well, first of all, let me say that it’s impossible to avoid the tax completely. That’s a recipe for getting yourself into big trouble. But what you can do is treat your self-employment work as a real business, and pay yourself a salary from the profits of the business. When you do that, the salary is the only part that is subject to the 15.3% FICA tax (or self-employment tax). Anything you make above the salary will flow through to you as business profits (otherwise known as “corporate dividends” in this context), and will not be subject to FICA taxes.
Keep in mind that both the salary and the profits are subject to regular income taxes as well, but that’s a separate tax, and you would pay the same amount whether you paid yourself a salary or not.
File as an LLC and Elect to be Taxed as an S Corporation
To do this, you have to formally structure the business so that the business pays you a salary, and then distributes profits on top of the salary (if there are any). In other words, it cannot simply be a sole proprietorship or partnership anymore, which are the default tax filing statuses for most business owners or freelancers. While there are some advantages in simplicity with those business structures, you have probably outgrown them anyway if you are starting to make some significant income.
Once you’ve decided to incorporate, you need to choose a business entity. While there are several different business structures out there to choose from–each with their own unique advantages and disadvantages–the ones I see used most often are an LLC (with a special election to be taxed as an S corporation) or just simply an S corporation. (Choosing a business structure is way beyond the scope of this article. Please consult with both your attorney and tax preparer before making this decision.) However, it is important to know that this strategy cannot be done with a C corporation business structure, but most small businesses will not be interested in that option anyway.
Once you have a business entity setup, you can set your salary at a level the IRS deems as “reasonable compensation.” What is reasonable is different in each person’s eyes, and some tax preparers are willing to get more aggressive with this than others. But in my opinion, you can set yourself a fairly low salary compared with the market rate if you are just starting out, based on the lack of experience in the industry. Now, on the other hand, if you are a seasoned professional branching out on your own, you might have to find a spot on the low side of the market range for a position similar to yours. (At the end of the day, your tax preparer can best guide you on how “aggressive” you can be with setting a low but reasonable salary.)
Set Your Salary at the Lowest Reasonable Amount
At any rate, you want to set your salary low enough to pay as little FICA as possible, without raising the ire of the IRS. Here’s an example of how much this might save you: Imagine you’re a self-employed dog groomer. Business is good and this year you anticipate $100,000 in gross sales. After expenses, you should take home about $80,000.
As a sole proprietor, all of that income will hit Schedule C of your tax return, and be taxable both for ordinary income taxes and self-employment taxes. Assuming no personal exemptions or deductions (just to keep things simple), I calculate your ordinary income tax for 2017 at $15,739. That’s the ordinary income part, which you have to pay whether the income is categorized as salary or profits. In addition, as a sole proprietor, you also have to pay 15.3% of self-employment tax on that $80k. That’s a whopping $12,240 on top of the $15,739, for a total of $27,979 in tax, and that’s before even looking at state taxes. (Again, I’ve left out personal exemptions and deductions on the ordinary income tax side, which will vary for every person. I’m just trying to give you the big picture here.)
But here’s where things get interesting. If on the other hand, you were to form an LLC and set yourself a salary of $30,000, assuming that’s a reasonable entry-level dog groomer salary. (I must confess I know nothing of the dog grooming industry, so this is completely hypothetical.) In this case, you would pay the 15.3% on the salary portion only, and therefore save yourself 15.3% times $50,000, or $7,650!
Granted, there are a few hoops to jump through such as forming the LLC, filing a corporate tax return, and paying yourself the salary piece, I think we can all agree that it’s worth it for that kind of money. (Again, small business bookkeeping, accounting, and taxes are complicated. I highly recommend you consult your tax preparer or CPA before attempting to implement anything you read in this article to ensure that this strategy is right for your situation.)
What are the Disadvantages of Incorporating Your Business?
In tax planning, there is rarely a strategy that has only advantages, with no drawbacks at all. In the case of incorporating your business, the disadvantages are mostly in the form of a “hassle factor.” First, you have to choose a business entity and register it with your state government. Then, you have to pay yourself a salary from the business entity on a regular basis. Some accountants prefer simply paying the payroll one time at the end of the year, but others require you to pay it on a more regular basis.
Either way, you have to pay to do the required payroll filings or figure out how to do them yourself. While they usually aren’t prohibitively expensive, they do cost something, and you just want to make sure that your saving enough in the first place to make it worth your while.
In addition, at the end of the year, your tax preparer will also have to file a corporate tax return for the business, in addition to your personal return. Since you are filing as an S corporation (whether as an LLC electing to file as an S corporation or simply because your business is an S corp), there are no additional taxes on the corporate level. It is an informational return only. However, it still has to be filed, and it will usually cost a few hundred dollars to pay your tax preparer to do this return as well.
It can really pay to know all of your options when it comes to taxes, and filing your self-employment earnings as a corporation can often help you save big time. Never make a move such as this before consulting with a credentialed tax preparer, and be sure to talk with him or her early enough in the year to implement this strategy. (Some states require payroll taxes to be paid at certain regular intervals, so the earlier in the year you start, the better.)
Last, once you have implemented a strategy such as this, might I suggest funneling your savings into a Roth IRA? Check out my recent guide to why a Roth IRA is your ultimate retirement saving tool.
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