In a nutshell, an S corporation allows a business owner to avoid payroll taxes on a chunk of the business profits as long as he or she pays the owner or owners reasonable compensation.
An S corporation, however, often also delivers other substantial tax savings to small business owners. And in this post, I want to identify three such benefits.
Quick Review of the Well-known S Corporation Benefit
Let me, though, before I get into the little known benefits of an S corporation quickly review the big, well-known benefit of an S corporation. This will put all of us on the same page.
If you run a sole proprietorship that makes a $100,000 a year in profits or you’re a partner in a partnership that generates a $100,000 distributive share, you pay two taxes on your income.
You pay income taxes. (This tax might often be between $10,000 and $20,000 depending on your other income and what deductions you take.)
And you also pay a 15.3% self-employment tax—the business owner’s version of Social Security and Medicare tax—on the $100,000.
The math is a little more complicated than this, but you can think about the 15.3% tax on the $100,000 as being roughly a $15,000 tax.
However, if you operate the exact same business as an S corporation and you split the $100,000 of sole proprietorship profits or the $100,000 of partnership profits into $50,000 of wages and $50,000 of distributive share, you only pay the 15.3% tax on the $50,000 of wages.
The savings of an S corporation in this example equals (roughly) 15% of whatever amount you call a distributive share. (People often describe the distributive share as a “dividend” but the technically precise term is distributive share.) And in this case, the accounting means you save roughly $7500 in payroll taxes annually.
The preceding paragraphs describe the well-known benefit of operating as an S corporation. But in addition to that benefit, S corporations potentially offer up three other big benefits to small business owners.
Selling the Business
For example, did you know that an S corporation supplies one of the easy ways for you to sidestep the net investment income tax if you sell your business? This is the tax that sometimes people refer to as the Obamacare tax. But let me explain.
If you someday have the good fortune to sell your business, the profits from that sale will be subject to either ordinary income taxes or capital gains taxes.
In addition, if the sale of the business pushes your income above $200,000 and you’re single or the sale pushes your income above $250,000 and you’re married and you file a joint return, profits on the sale may also get hit with the Sec. 1411 “Obamacare” 3.8% net investment income tax. (This would be case, for example, if you’ve operated your venture as a regular corporation.)
However, the net investment income tax doesn’t apply to sales of the assets of an S corporation or the stock in an S corporation if you’re actively involved in the business.
In other words, if you make 200,000 or $2,000,000 or $20,000,000 selling the assets of your S corporation or your S corporation’s stock and you’re actively involved in the business, you don’t have to pay the 3.8% net investment income tax. (Again though you will still pay ordinary income taxes or capital gains.)
Subchapter S corporation status can thus easily save a business owner thousands of dollars in taxes when the business owner sells out. And in a giant windfall situation, subchapter S status can save the business owner hundreds of thousands or even millions of dollars. Wow.
Tapping the DPAD Deduction
Here’s another little known benefit of Subchapter S corporation status that small one or two person businesses can sometimes use to save big.
If you run a sole proprietorship or a small partnership that makes stuff, grows stuff, or mines stuff, you’re eligible potentially for the Sec. 199 domestic production activities deduction, also known as the DPAD deduction.
The DPAD deduction—and this is an absolute loophole—lets eligible businesses deduct an amount equal to 9% of their business profits from their income. But there’s a requirement that commonly causes very small businesses to miss the deduction: The actual deduction can’t exceed fifty percent of your wages.
To show you how this works (or doesn’t work) suppose you run a small construction company or a digital goods company and you make $100,000 a year. You are potentially eligible to deduct $9,000 from your income… but not if you don’t have at least $18,000 of wages.
The rub is that if you’re really the only person working in the business and the business operates as a sole proprietorship, you don’t have wages. Or if the only people working in the business are two partners, again, the business doesn’t have wages.
The wage-based limitation evaporates if the sole proprietorship or partnership reforms as an S corporation, however. If the $100,000-in-profits sole proprietorship incorporates and makes an S corporation election, for example, the proprietor will need to pay out some of the $100,000 in profits as wages. But these wages will then let the business take the DPAD deduction.
For example, if the S corporation splits the $100,000 of profits into $50,000 of wages paid to the proprietor and $50,000 of distributive share, the business profit will equal the $50,000 of distributive share and this means the DPAD deduction will equal 9% of $50,000 or $4500. That $4500 deduction might save the taxpayer $1000 to $2000 in taxes depending on their other income and deductions.
Note: The DPAD deduction is regularly missed by small businesses, so if you run a manufacturing operation, a construction firm or a firm selling digital goods or digital services, you should look at line 35 of your federal 1040 return to verify you’re benefiting from this easy loophole. If the line shows no deduction value, talk with your tax adviser. You can also get some additional data on this deduction in another blog post here.
Double Deducting Pension and Health Insurance
One other little known benefit deserves mention, though it’s subtle in its effect.
If you operate as a sole proprietorship or partner in a partnership, the self-employed health insurance deduction and your pension contribution save you income taxes (assuming you’re eligible and follow the rules.) But these deductions don’t save you payroll taxes.
However, because electing Subchapter S status has the effect of moving these deductions onto your S corporation tax return, Subchapter S status often in effect lets you save not just income taxes but also payroll taxes on self-employed health insurance and pension deductions.
The accounting gets a little messy, I acknowledge that. To get what amounts to a double-deduction for the self-employed health insurance, you need to prepare the shareholder-employee’s W-2 in a very precise and proper manner. (Here’s more information about this.)
And the double deduction for a pension contribution doesn’t work for the elective deferral chunk of the deduction. This means that you can get a double deduction for SEP-IRA contributions, defined benefit plan contributions and the employer match on a 401(k) plan or Simple-IRA plan… but not on the elective deferral chunk of a 401(k) or Simple-IRA contribution.
Nevertheless, this double deduction business can make the difference as to when Subchapter S status makes sense. Sometimes one-person businesses or small partnerships that can’t otherwise justify the Subchapter S election should still elect S status due to the double-deductibility they’ll get from health insurance and pension deductions.