In a few weeks, one tax year ends and a new tax year starts. For that reason, it makes sense to talk about a powerful tax strategy for small businesses: The one person S corporation.
In some cases, a small business may still be able to treat their business as an S corporation for the year ending soon. And in most cases, a small business can begin operating as an S corporation next year.
Reminder: Get the complete list of tax strategy posts here: Tax Strategy Tuesday.
One Person S Corporation Tax Strategy in Nutshell
The best way to showcase the power of the one person S corporation is by comparing the payroll taxes a sole proprietor pays with the payroll taxes a one person S corporation pays.
Let’s use the simple round-number example where a small business earns $100,000.
If this entrepreneur operates as an sole proprietorship, he or she pays not only income taxes but a 15.3 percent self-employment payroll tax on 92.35 percent of the $100,000.
Do the math, in fact, and the formula calculates roughly $14,000 of payroll taxes.
If this business operates an an S corporation, however, and she or he earns $100,000 in profits, the taxes work differently.
In a nutshell, the business owner decides what portion of the $100,000 to call out as wages. And then he or she pays the 15.3% payroll tax on just that portion. (The business owner will pay essentially the same income taxes.)
If a business says, for example, that $40,000 of the $100,000 should be wages—and then does the payroll tax accounting correctly—the business owner pays roughly $6,000 in payroll taxes.
And that’s where the S corporation tax savings show up: $6,000 in payroll taxes instead of $14,000 in payroll taxes.
One key, key issue here won’t surprise you: Tax law requires the business to pay the owner reasonable wages.
Tricks that Make One Person S Corporation Tax Strategy Work
Many one person S corporations deliver generous tax savings to their owners by setting the owner wages too low. But you don’t want to do that. Further, knowledgeable, reputable tax accountants never condone that approach. And usually, they refuse to knowingly enable that approach.
But two tricks often allow a business to safely set a very modest salary that saves big amounts.
One trick: Load up the S corporation’s tax return with tax-free fringe benefits for the shareholder-employee. Essentially, these count as compensation but don’t trigger payroll taxes.
Example: James used to operate a sole proprietorship that generated $100,000 in business profits and paid roughly $14,000 in self-employment taxes. He now operates as an S corporation and pays himself $40,000 in wages. That means he pays roughly $6,000 in Social Security and Medicare taxes, thereby saving roughly $8,000 annually in payroll taxes. He and his accountant consider this approach reasonable because of the extremely generous tax-free fringe benefits the S corporation provides: $12,000 of health insurance, an $8,000 health savings account, and a $15,000 employer pension fund contribution.
A second trick: If an S corporation retains earnings for business purposes, the business owner sidesteps paying payroll taxes on that money.
Example: James from the preceding example shows $25,000 of leftover S corporation profit after paying modest wages and generous fringe benefits to him. He pays income taxes on the $25,000 but not payroll taxes due to the S corporation. Probably that’s very safe if he retains that $25,000 as working capital in the business. For example, as cash in the company checking account. Or dollars invested in inventory.
Possible Tax Savings from One Person S Corporation Tax Strategy
Operating a business as an S corporation rather than as a sole proprietorship often saves a one-person business owner many thousand dollars annually. Further, unlike many tax reduction schemes, S corporation tax savings often count as permanent tax savings that roll on for years and years.
Someone who reduces their taxes by, say, $8,000 a year via a $25,000 or $30,000 pension fund contribution probably pays that tax back—or some of it anyway—later on when the taxpayer withdraws the funds.
Example: John reduces his tax bill by $8,000 annually through a pension plan to which he contributes $25,000 each year. Over his working years, he hopes to accumulate $1,000,000 in his retirement account. At that point, though, he’ll begin drawing $40,000 a year. And he’ll probably at that point pay $6,000 or $8,000 in taxes annually.
With an S corporation, in comparison, the taxpayer never pays back the annual payroll tax savings. If the tax payer saves $8,000 a year, for example, she or he gets to keep that money.
Turbocharging the One Person S Corporation Strategy
Higher income one person S corporations need to carefully check the math. But if a taxpayer’s income rises high enough, an S corporation may generate additional savings. Those savings? The Section 199A deduction.
If a taxpayer’s taxable income, for example, equals $500,000, a taxpayer’s business needs W-2 wages in order to qualify for the Section 199A deduction.
Example: Rutherford and Calvin both operate one person businesses that generate $500,000 in taxable profits. Rutherford’s business operates as a sole proprietorship and so pays zero wages. As a result, he receives no Section 199A deduction. Calvin, in comparison, operates as a one person S corporation and pays himself $150,000 in wages and $50,000 in fringe benefits. That leaves $300,000 of leftover S corporation profit. And he gets a $60,000 Section 199A deduction.
Note: The simple version of the Section 199A formula says a taxpayer gets the lesser of 50 percent of the $150,000 of wages or 20 percent of the $300,000 of business profit.
Limits to Tax Strategy
Small business owners have used the one person S corporation gambit for nearly seventy years. And often with great results. But several limits exist to using the strategy.
First, relatively high fixed costs mean the strategy often fails to generate net savings for the smallest small businesses. Especially for part-time or sideline ventures operated by someone who works full-time at a regular W-2 job. Note that extra accounting costs often run $2,000 annually. So, the first couple of thousand dollars a small business saves in payroll taxes go right back out the door to pay for accountants and payroll services.
Second, not every business qualifies to be an S corporation owner. As a simplified rule of thumb, only U.S. individual taxpayers qualify to own shares in an S corporation. (Some wiggle room exists with regard to eligible shareholders so talk with your tax advisor about the detailed rules.)
Third, as incomes rise, the payroll tax rates change: Payroll tax rates start at 15.3 earnings (up to $147,000 in 2022). Ratchet up to 3.8 percent at $200,000 of earnings. And then, between the 15.3 and 3.8 percent tax brackets, a 2.9 percent bracket exists. (That bracket is shrinking every year due to inflation adjustments in the 15.3 percent limit.) And the point here: One person S corporations fairly easily generate payroll tax savings when the taxpayer avoids the 15.3 percent tax rate. But not so much when the taxpayer avoids the 2.9 percent or 3.8 percent tax rate.
How This One Person S Corporation Strategy Can Blow Up
The IRS rarely audits S corporations and so rarely challenges one person S corporation salaries. Ironically, then, small business owners probably don’t need to worry too much about that. (This is not the same thing as saying you can ignore the rules, by the way. Don’t ignore the rules.)
But the one person S corporation strategy easily can “blow up” for other reasons.
For example, some small businesses lack the organizational aptitude to operate the accounting system and the formal payroll system required. (If someone can’t do a regular payroll or run bookkeeping software like QuickBooks, Xero or FreshBooks, that’s a signal the one person S corporation thing may not work well.)
Another factor to consider: A small business needs basically either a corporation or limited liability company to function as the foundation for the S corporation. In effect, the whole S corporation thing is just a bookkeeping approach these types of legal entities use. Accordingly, the one person S corporation needs to be willing to deal with her or his state’s legal red tape.
A caution for existing businesses with debt: When an LLC elects to be treated as an S corporation, that triggers a deemed incorporation of the small business. Usually for a one person S corporation, that deemed incorporation triggers zero income taxes. But if the LLC owes liabilities (such as a vehicle loan), the deemed incorporation can trigger a large tax bill. Taxpayers in this situation should consult their tax advisors.
Finally, this caution: The Build Back Better Act proposes eliminating the S corporation gambit for high income taxpayers. (We’ve got a longer blog post here that explains how that works: Build Back Better Hits High-income S Corporations.)
The One Person S corporation Strategy Works Best for These Taxpayers
The one person S corporation works best when someone makes either a high five or low six figure profit and then can pay a reasonably low salary. As suggested in the earlier, the approach also works best when the business tax return shows lots of tax-free fringe benefits.
Accordingly, many independent contractors working as skilled tradespeople, consultants and professionals can make the strategy work well.
Through 2025, an S corporation can also work with very high income taxpayers if the taxpayer qualifies for the Section 199A deduction by having the business pay wages. Big income real estate brokers, some doctors, software engineers, and a handful of other special case situations fall into this category.
Timing of Strategy
Regarding timing, by the way, a small business operating as an LLC throughout the past year—so the LLC existed on January 1 of the current year—can elect to be treated as an S corporation for year. Even rather late in the year. To do that the business owner or his accountant files a 2553 form with the IRS. And the business owner needs to pay a reasonable amount of shareholder-employee compensation before December 31.
Note: Technically, in order to elect S corporation status as of January 1 for some year, the IRS needs the 2553 form by March 15 of that year. The IRS allows late elections, however, if the business provides a good excuse.
Other small businesses practically want to wait until the start of the next year. And they want an LLC or corporation already formed by January 1 of that next year.
Example: Martha wants to operate her small business as an S corporation as soon as possible. But she doesn’t yet operate the business as a corporation or limited liability company. Accordingly, what she does is form an LLC late in the year and then elect to use S corporation status starting January 1 of the next new year.
Other Information Sources
If a small business wants to set up a limited liability company, we have free downloadable kits you can access at his page: downloadable limited liability company kits.
Over the years, we’ve accumulated quite a bit of background information about S corporations. If you’re just starting your research, you may find these blog posts useful: The Million Dollar S corporation Mistake, S Corporation Reasonable Compensation, and IRS S Corporation Shareholder Salary Data.
Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, please consider contacting us: Nelson CPA.
Tip: If some accountant or consultant suggests that you can form a corporation or LLC late in the year (so say December of the current year) and then retroactively elect S corporation status as of January 1 of the current year. So months earlier than the corporation or LLC even exists? That person doesn’t understand enough about S corporations to be providing you with professional advice. Sorry.