Many freelancers, small business owners, and entrepreneurs are leaving a lucrative tax strategy on the table, and it’s costing them loads of money. If you’re looking to reduce your taxes, pull up a chair for five minutes to learn more about s-corp distributions.
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Tax Saving Method: S-Corp Distributions vs. Wages
A lot of entrepreneurs and freelancers fail to establish a formal business entity, and it’s a big mistake. Though it may cost more initially, the tax-saving benefits can be immense. S-corps, for example, are often a great option for many operations, as they allow for shareholders to claim both wages and distributions.
What is a distribution? It’s the amount of money associated with one’s share of a company. A wage, on the other hand, is an amount paid in exchange for work.
Tax Saving Method: Paying Yourself vs. Taking an S-corp Distribution
Self-employed people must pay an additional 15.3% in taxes for social security and Medicare. So, let’s say you make $100,000 in a year after state tax and other deductions. (Also, for the sake of example, let’s say you’re filing as a single person.*) You would have to pay $39,300 in federal taxes (15.3% + 24% = 39.3%), leaving you with $60,700.
But wages and distributions carry different tax obligations. You must pay income tax on wages. Distributions, on the other hand, are tax-free. Yes, business must pay taxes before distribution allocation, but remember that companies have more deductions at their disposal than individuals.
So let’s take that same post-deduction $100,000. If you established an s-corp and paid yourself $33,300, instead of the full amount, your federal income tax would be $9,091 (15.3% + 12% = 27.3%) in federal taxes. Then, you could receive the remainder of the profits as a tax-free distribution.
Can I Claim a $1 Salary and Take the Bulk as an S-corp Distribution?
You may be thinking: Super! I’ll set up an s-corp, pay myself a $1 salary, and then take the remainder as a distribution. Unfortunately, that’s not a viable option. The law requires businesses to pay “reasonable compensation” to employee shareholders for services rendered. Failing to do so can lead to an audit and massive fine.
What constitutes “reasonable compensation”? Well, the IRS has never published detailed guidelines, but accountants and tax lawyers typically suggest following one of two methods:
- Divide the corporation’s profits into thirds: 1/3 for business expenses, 1/3 salary, and 1/3 distributions.
- Determine the national wage average for the work and use that figure.
The IRS Is Persnickety about Distributions; Work with A Professional
The s-corp distribution tax strategy could save you loads of money, but it also has the potential to land you in trouble with the IRS if misapplied. That said, the method could significantly slash your tax burden. The big guys use it, and so should you.
Interested to learn more or determine if you can use the s-corp distribution tax strategy? Let’s talk. Our tax law consultancy works with people across the United States and around the world — and we know how to lower tax bills while remaining compliant. Get in touch today to start exploring your options.
*Deductions and withholdings vary depending on marital status.Let's Discuss How To Lower Your Tax Burden »