Why an S Corporation Reduces Self Employment Tax-Legally!!

July 1st, 2022 at 11:01 AM

If you report your business on Schedule C of your Form 1040, or are a general partner, this article is for you!

Have you noticed that the self-employment tax significantly drains your cash? The S corporation may plug a good chunk of that leak because only the W-2 wages that the S corporation pays to you would be subject to federal income taxes, & State & Local---but NOT social security and medicare taxes!

Here’s the big picture: The S corporation

• deducts the W-2 wages;
• passes the remaining taxable income to you—the shareholder who reports the income on his Form 1040; and
• makes cash distributions to you—the shareholder.

The passed-through S corporation taxable income increases the tax basis of your stock; therefore, distributions of corporate cash flow are usually federal-income-tax-free.

This tax structure places S corporations in a potentially more favorable position than equivalent businesses conducted as sole proprietorships, single-member LLCs that are treated as sole proprietorships for federal tax purposes, partnerships, and multi-member LLCs that are treated as partnerships for federal tax purposes.

That’s because S corporations can follow the tax-smart strategy of paying modest salaries to shareholder-employees while distributing most or all of the remaining corporate cash flow to them in the form of federal-employment-tax-free distributions.

Mark S. Fineberg, CPA