S Corp Tax Deductions: A Plain English Introduction

Written by Chelsea Baldwin on November 6, 2017

In theory, I have no opposition to paying taxes. What kind of decent person wouldn’t want to use their good fortune to give back to society to fund services like the police department, education for our children’s future and programs that help lift up those who are less fortunate?

In practice (and especially before I learned about S Corp tax deductions), I’m a little less thrilled about paying them. Yes, I’m the nerdy, responsible type who sets aside a predetermined percentage of my income every month into a savings account dedicated solely for paying taxes. But when tax time comes around every three months and I have to send off checks worth thousands of dollars to state and federal governments, it doesn’t feel so good.

No, I don’t want to send in six months’ worth of rent payments, thank you very much! As a self-employed person, I’m continually paying more than my traditionally employed peers in taxes — because they have employers who pay payroll taxes on their behalf, and I don’t.

Save Money on Taxes With an S Corp

I have to admit: When my accountant first explained this to me, I thought it was a hoax. Could I really slash my tax bill by thousands of dollars just because of a technicality when it came down to paperwork?

Turns out, I could.

I met my new accountant in early 2017, and when he reviewed my 2015 taxes, he told me I could’ve saved $2,000 in S Corp tax deductions … even after paying the fees of filing S Corp paperwork and paying a payroll firm to process payroll taxes for me.

I don’t even know what I could’ve saved on taxes in 2016, when I nearly doubled my income from the previous year. So in 2017, I’m not making the same mistake again. CPA Stephen L. Nelson does a great job explaining this tax loophole with useful examples.

Understand What an S Corp Does, and How

According to Investopedia, an S Corp is “a form of corporation that meets specific Internal Revenue Code requirements, giving a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. The corporation can pass income directly to shareholders and avoid the double taxation that is inherent with the dividends of public companies, while still enjoying the advantages of the corporate structure.”

So even if your business only has one shareholder (you), you still qualify.

The thing that lets you save money on taxes, though, is this: “Shareholders may be employees of the company, draw employee salaries and receive corporate dividends or other distributions that are tax-free in relation to each shareholder’s investment in the business.”

Yes, you read that right. Tax-free dividends.

Even though you’re still just a business of one, you put on another “layer” where your LLC becomes a business that pays you as an employee. Your business is now responsible for paying payroll taxes … which reduces the amount you owe in income tax. And since your dividends are tax-free, that’s income that you don’t have to pay social security tax on. (Payroll tax and social security tax are essentially the same thing — the name just changes depending on whether it’s a business or an individual paying it.)

Sometimes, close to half of what you pay yourself as a business owner can be considered a dividend. This all just depends on your situation, and you’ll need an accountant to help you figure it out. Yes, you’ll still be paying taxes. But you won’t be paying as much, which is a lifesaver for self-employed indys like us when every penny counts.

See If an S Corp Makes Sense for You

Here’s the catch: Filing to establish an S Corp and having someone professionally handle your payroll costs money. So you won’t want to establish an S Corp if you’re not making enough in your business to at least break even.

To break it down for you, here’s a list of the costs involved:

  • Establishing an LLC, if you don’t already have one — because you need an official business in place before you turn it into an S Corp

  • The cost to file paperwork to establish an S Corp

  • The cost of payroll setup and maintenance

  • How much you paid in taxes last year vs. how much you could’ve paid if you had an S Corp in place

Note: Since filing is done at the state level and each state will have slightly different fees, I haven’t listed exact fee prices here. A good small business accountant will be able to rattle these numbers off the top of his head, so it’s nothing you can’t easily find out with a quick five-minute phone call.

Once you know these numbers and find out that your tax savings are greater than the administrative costs, it’s time to establish an S Corp. Even if you have to pay an accountant an hourly fee to consult and guide you on this, it’ll be so worth it if you end up saving money in taxes — or at least know at what point you’d start saving money, if it’s not that time yet.

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