Using an S-Corp Election to Reduce Self Employment Tax
Most independent contractors don’t think of themselves as a “corporation” but to save on taxes you may want to consider an S-Corporation election. As an independent contractor operating as a sole proprietor, all income is subject to self-employment tax. By electing S-Corp status and splitting your income between a reasonable salary and distributions from the business you can potentially reduce the portion of your income subject to self-employment taxes.
What is an S-Corporation?
An S-Corporation, is a specific type of corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. In the case of an independent contractor, operating as an S-Corp, the independent contractor would be the only shareholder. IRS rules require that shareholders working in the business pay themselves a reasonable salary. Earnings beyond the salary can be transferred to the shareholder as a distribution.
What is the self-employment tax?
The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security and 2.9% for Medicare. The social security part is only applied to a portion of your earnings. In 2024 it applies to the first $168,600 of your net earnings. You are liable for an additional 0.9% Medicare Tax if your wages, compensation, or self-employment income (together with that of your spouse if filing a joint return) exceed the threshold amount for your filing status. In 2024, the threshold is $125,000 for single filers and $250,000 Married Filing Jointly.
Payroll Taxes: Salary vs. Distributions
The shareholder of an S-Corp must pay payroll taxes (social security and Medicare), which are the same rate as the self-employment tax, on the salary portion of compensation. Distributions are not subject to the payroll tax which is where the tax benefits are recognized.
What to consider?
Before making the decision to convert you will want to do a cost-benefit analysis. While you might save money on taxes you will likely incur more administrative costs. For one, tax preparation fees will likely be higher because the S-Corp will have to file a tax return and issue K1s for distributions. To process payroll and account for the payroll tax withholdings you will also likely need a payroll service provider.
Switching from Sole-Proprietor to S-Corp
In the case of an independent contractor converting from a sole proprietorship it needs to happen in two phases. First you must establish a business entity by setting up a Limited Liability Company (LLC) which is legal entity (not tax status) at the state level. The LLC can then elect to be taxed as an S-Corporation by completing IRS Form 2553. The ideal time to set-up the S-Corp is in the beginning of the year, but you can do it anytime and can even do it after the end of the year before you file your taxes.
In addition to reducing taxes through an S-Corporation election, independent contractors will also want to carefully consider the different retirement plan options available to them to maximize tax deductible savings.