How to Reduce Taxes with an “S” Corporation

Consider the tax benefits of an "S" Corporation when determining your corporate structure.

Author: Dirk M. Roskam
Date: 04/25/2005

One of the decisions that needs to be made when incorporating a business in Michigan is what type of corporation the business will be. The 2 most common are C corporation and S corporation. The S corporation option has the benefit of saving business owners taxes in three ways:

Benefit 1:
Compared to regular C corporations, S corporation owners can use the business’s losses—such as those incurred during the startup phase—on their personal returns as deductions. This “S corporation advantage” is also shared by single member and multiple member limited liability companies (LLCs) electing default treatment. EXAMPLE: A new business, organized as an S corporation, incurs $20,000 of losses in its first year. If the business is equally owned and operated by two shareholder employees they each get a $10,000 business deduction on their individual tax returns. This $10,000 deduction might save them each as much as $4,000 in federal and state income taxes.

Benefit 2:
Compared to almost every other business form, S corporations can save their owners self-employment or Social Security/Medicare taxes. EXAMPLE: Three individuals each independently own businesses that make $90,000 a year in profits. Each business owner may pay $13,000 in income taxes. Unfortunately, that’s not the only tax they pay. Each owner also pays self-employment or Social Security/Medicare taxes. To illustrate, business owner #1 operates his business as an LLC taxed as a partnership and therefore pays 15.3%, or roughly $13,500, in self-employment taxes on his profits. Business owner #2 operates his business as a C corporation, which pays all of its profits to him as a salary. Accordingly, he (through his corporation) also pays 15.3%, or roughly $13,500, in Social Security and Medicare taxes. Business owner #3’s situation is different. She operates her business as an S corporation, which means she can split her $90,000 of profits into two payment amounts: salary and S corporation distributions. Suppose that she says only $30,000 of her profits is salary. In this case, she pays the 15.3% Social Security/Medicare tax only on the $30,000 in salary. She therefore pays roughly $4,500 in Social Security/Medicare taxes—and saves $9,000 annually in taxes as compared to the other 2 business owners.

Benefit 3 (which may not be much of a benefit any more):
Compared to regular corporations, S corporations sometimes save owners taxes because S corporations don’t pay corporate income taxes. This means that S corporations avoid the often talked about “double-taxation” problem. But the “no corporate income taxes” benefit occasionally isn’t a savings for small corporations and their owners, as illustrated in the following example. Suppose that two corporations each earn the same pretax profit of $100,000 and are owned by an individual who pays a federal income tax rate of 35%. One corporation is an S corporation and the other is a C corporation. The S corporation can distribute the entire $100,000 in profits to the owner as dividends because there is no corporate income tax. He then pays $35,000 in personal income taxes on the S corporation profits, which means he nets $65,000 in after-tax profits from S corporation. In comparison, C corporation can’t pay the entire $100,000 in profits to the owner. C corporation first pays $22,250 in corporate income taxes. When C corporation pays the remaining $77,750 to the owner as a dividend, he pays another $11,663 in 15% “dividend” taxes. This means that he nets roughly $66,000 in after-tax profits from C corporation. In this case, he saves money with a C corporation in spite of having to pay the corporate income tax. This ability to pay all profits out as dividends is also dependent on the amount of active participation the business owner has. If you’d like help in determining whether or not an S corporation will save you taxes, please feel free to contact our office. We’d be happy to assist you.