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Calculate Your Tax Savings By Incorporating

To learn how to use this feature click here

Step 1. Enter your estimated annual earnings from your business or occupation?	$
Step 2. Enter a percentage of these earnings to be paid to you as salary?	%
Step 3. Click "Go" to calculate your payroll tax savings! (Your savings is shown in the last box below.)

Sole Proprietorship				"S" Corporation
Your Annual Earnings	Self Employment Taxes:		Total Self Employment Taxes	Earnings Paid As Salary	Earnings Paid As Distribution	Social Sec. Tax (12.4%)	Medicare Tax (2.9%)	*Your Annual* Tax Savings $$$**
	Social Security	Medicare

Discussion

Forming a corporation and electing to be an "S" corporation under the Internal Revenue Code can offer substantial payroll tax savings to a sole proprietor. Here are the reasons:

All sole proprietors must pay self-employment (SE) taxes on income earned from their business. The total tax rate is 15.3%. This is comprised of 12.4% for Social Security on all income up to $87,000 in 2003, and 2.9% for Medicare with no wage limit.
Payroll taxes must be withheld from employees' paychecks. The percentages and wage limits are the same in a corporation as for a sole proprietor, but the employer (corporation) and employee each pay half of both taxes.
In a "C" corporation (one that has not made an "S" election), it is not advantageous to distribute profits to shareholder-employees in the form of dividends since these are not deductible by the corporation. Profits are typically distributed in the form of salary bonuses, another form of compensation subject to the payroll taxes described above.
"S" corporations have another option because they are "pass through" tax entities. This means that they pay no federal taxes on profits. Instead, profits are automatically distributed to shareholders proportionately according to their ownership interests. These "distributions" of profit are not considered compensation and are not subject to payroll taxes.
By allocating the total income to shareholders between "compensation" and "profit distributions," there is a potential for substantial tax savings.

The following table further illustrates the kind of payroll tax savings that can be realized in an S Corporation using various earnings amounts and salary allocations.

The table assumes the same amount is paid to an individual either as a sole proprietor or as a shareholder-employee of his or her S corporation. However, while all of the earnings of the sole proprietor are subject to payroll tax deductions, only the salary portion of the S corporation earnings are subject to payroll taxes. The remainder of the S corporation earnings are paid to shareholder-employees as a non-salary distribution of profits.

The last column of the table shows the payroll tax savings to the S corporation based on the amounts allocated in this fashion.

Sole Proprietor			S Corporation
Annual Earnings (same for S corp)	Amount Subject to SE Taxes	Total SE Taxes Paid (A)	Earnings Portion Paid As Salary	Earnings Portion Paid as Profit Distribution	Total Payroll Taxes on Salary Portion (C)	Tax Savings Over Sole Proprietor (A) - (C)
35,000	35,000	5,355	10,000	25,000	1,530	3,825
50,000	50,000	7,650	20,000	30,000	3,060	4,590
75,000	75,000	11,475	25,000	50,000	3,825	7,650
100,000	100,000*	13,688	30,000	70,000	4,590	8,838
200,000	200,000*	16,328	50,000	150,000	7,650	8,678

* Subject to $87,000 wage limit in 2003 on 12.4% Social Security Tax portion of payroll taxes

Other considerations favor the selection of an S corporation:

In a C corporation, if a year-end bonus is continually used to eliminate a corporation's taxable income, there is an increasing risk that the IRS may claim that bonus payments were really disguised shareholder dividends. Since dividends are not tax deductible like salary payments are, this increases the corporation's tax and results in double taxation of income.
Since the defining characteristic of S corporations is the automatic "pass through" to the shareholders of the corporation's taxable income, with no federal income tax obligation by the corporation, there is no issue of reasonable compensation of shareholder-employees to be raised by the IRS. The only IRS focus may be a claimed underpayment of payroll taxes, but the payment of even a "modest" salary provides little basis for the IRS to successfully argue that an "unreasonably low" compensation has been paid to a shareholder-employee.

Important Note: You should always consult your personal financial advisor to determine the percentages of your earnings that are appropriate to allocate to salary and profit distribution for your particular occupation or profession, especially if your earnings are primarily from your personal services.

To learn more about S corporations, including the requirements for electing "S" status, additional advantages and the disadvantages, click here.