Bad or erroneous tax advice costs small business owners in all sorts of ways. But deciding not to run a successful small business as an S corporation may rank as the very worst mistake an entrepreneur can make. In fact, we should probably call this the “million dollar S corporation mistake.” Because missing the S corporation opportunity may cost you and your family a million dollars.
Let me run you through the math. And then you can decide whether I’m right or merely exaggerating.
Reviewing the S Corporation’s Tax Saving
Let’s start by coming up with a reasonable estimate of what an S corporation might actually save you in the way of annual self-employment taxes.
Suppose, for example, that you have a successful small business making $120,000 a year in profits. If you do the self-employment tax calculations that get reported on Schedule SE, you’ll pay about $17,000 in self-employment taxes in this situation.
Note: A rough estimate of the self-employment tax you pay if you make roughly the FICA tax limit or less is 15% of your wages. But you can get more precise by applying the actual 15.3% tax to an “adjusted for the self-employment taxes” measure of your income. The easiest way to do this is to actually work through the Schedule SE form’s calculations.
To determine whether you save payroll taxes with an S corporation, you need to compare the self-employment taxes you pay on your business profits if you operate as a sole proprietorship with the Social Security and Medicare taxes you pay on the “substitute” wages you’ll receive from your S corporation if you’re an owner-employee.
In a situation like the one described here, for example, you might pay yourself $60,000 in base wages if the S corporation adds health insurance to your compensation and if the S corporation makes a SEP-IRA contribution for you. (More on all this in a few paragraphs.)
You need to work out the numbers for your situation. But if you did pay yourself a $60,000 wage and also provide yourself with $12,000 of health insurance, your W-2 box 1 wages equal $72,000.
If you also add to that $72,000 of W-2 wages a generous SEP-IRA contribution, you’re probably paying yourself reasonable wages. However, you’re only paying payroll taxes on that $60,000 of base wages.
Note: One of the interesting things that happens with an S corporation is that the self-employment health insurance deduction and the SEP-IRA deduction reduce not just your “subject to income taxes” income but also your “subject to self-employment taxes” income.
If you paid that 15.3% tax on only $60,000 of earnings rather than nearly $120,000 of earnings, you drop your payroll taxes burden to $9,180 annually.
So, just to make this clear: In a case like we’re discussing here, an S corporation drops your payroll taxes from roughly $17,000 a year to roughly $9,000 a year, creating nearly $8,000 of annual payroll tax savings.
Supercharging Your S Corporation Tax Savings
What you should probably consider doing, however, is using any payroll tax savings for a pension plan–and ideally a SEP-IRA plan since that means contributions bump up the shareholder’s compensation but in a manner that doesn’t trigger increased payroll taxes.
With $8,000 of payroll tax savings, you can actually make about a $9,200 SEP-IRA contribution. You get the extra money, that extra $1,200, from the extra tax savings the SEP-IRA contribution generates.
That $9,200 SEP-IRA contribution grows to about a $1,000,000 in real-dollar, adjusted-for-inflation terms if you run your S corporation for 35 years and earn a 6% real rate of return.
And so here’s the rub: If you can operate your venture as an S corporation but you don’t, you’re probably leaving a gigantic pile of money on the table. With a successful small business operation, you might even be making the million dollar S corporation mistake described in this post.
Note: I created a simple Excel workbook to do the calculations referenced in this post. You can grab a copy of that worksheet here: scorporationmilliondollarmistake
Flies in the Ointment
Let me, to be fair, point out some practical issues about the million dollar S corporation mistake.
First, the S corporation must pay its shareholder employee a reasonable wage. In a situation where the business made $120,000, paying the shareholder-employee a $60,000 base wages amount, a $12,000 health insurance benefit, and a $9,200 pension fund contribution is probably going to put you within the realm of reasonableness. But you’d want to carefully check.
Note: With $72,000 in combined base wages and health insurance benefits, a shareholder-employee would actually be able to contribute as much as 25% of that $72,000, or $18,000, to his or her SEP-IRA. That’d be an easy way to bump the total compensation number. Note that the earlier paragraphs of this discussion assume a $9,200 SEP-IRA contribution.
Second, you do lose some Social Security benefits if you run this gambit. Someone who earns $120,000 a year roughly gets a $30,000 annual Social Security benefit while someone who earns $60,000 a year roughly gets a $24,000 a year Social Security benefit. You and I would probably take the extra $1,000,000 or whatever rather than the extra $6,000 a year. But we want to be aware of this wrinkle.
A third, final point: Some other stuff happens when you operate as an S corporation. You’ll be burdened with some extra costs that you don’t have to pay if you’re only a sole proprietorship. You’ll gain some new benefits that you don’t enjoy now if you operate as an unincorporated business. The upshot here? You want to do a bit of research before you jump onto the S corporation band wagon.
Other Posts Related to the Million Dollar S Corporation Mistake
We talk a lot at this blog about Subchapter S corporations, but the three posts below are probably particularly helpful if you’re starting your research. And by the way note that if you do decide to form an S corporation that we provide downloadable, do-it-yourself S corporation kits for all fifty states.
Average S Corporation Shareholder-employee Salaries (at my S Corporations Explained website)