Grab a cup of Joe.  This is a long one, and you’re going to want to be alert.

It’s no secret:  You can save on income taxes by owning your business as an LLC (if you don’t already) and electing to be taxed as an S-Corp.

But, it’s kind of a murky mystery to most business owners, how.  It’s that magic thing your tax accountant is going to do—when you’re big enough.

The biggest myth of all is that you have to make a whole lot of income to benefit from this completely legit advantage to business owners.  Not true!

Electing to have your business taxed as an S-Corp can save you taxes at nearly every income level.  And saves you the most at $114,000.

Here’s why and how much.

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1.  Reduced Self-Employment Tax.  7.65% of your income (up to $114,000).

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That’s as much as $8721.  I don’t know about you but I can do a lot with $8000.

If you take home more or less than $114,000 from your business, keep reading.  The same rationale and percentage savings applies for incomes below that.  The savings decrease for incomes over that because your income over $114,000 is not subject to self-employment tax anyway. (But you can still save with an S-Corp for Reason No. 2 below.)

The first key reason an S-Corp reduces your income taxes as a business owner is because it allows you to cut your self-employment taxes in half.

Good-News-292x300This puts nearly an entire month (92%) of personal income back in your pocket.

(Yes, go ahead, read it again.  Be sure you read it right.  You save a month of personal income.)

Here’s why:

When you pass your business income through to you as an individual, you pay 15.3% self-employment on your entire income up to $114,000, which covers Social Security and Medicare taxes.  This is true whether you are a sole proprietor, a partnership or an LLC without S-Corp election.

When your business is an LLC taxed as an S-Corp, you can take (as a rule of thumb) half of your income as a distribution, which is not subject to Social Security and Medicare taxes.  This is because a distribution is a short-term capital gain on your investment in your business.  Social Security and Medicare taxes do not apply to capital gains.  (This is NOT the same as deducting half of the self-employment tax from your taxable income on your 1040.)

You take the other half of your income as a salary from your business and you do pay 15.3% in Social Security and Medicare on that.  It’s called a Payroll Tax.

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This offers you a tax savings at nearly every income level below $228,000.  So, let’s take a look at the low end.

If you take home $20,000 from your business, being taxed as an S-Corp will save you $1530 in self-employment taxes.  That means that, the first year, the tax savings will cover your investment in the LLC and S-Corp tax filing.  Every year after, assuming you take home at least $20,000, you’ll keep more money for yourself, based upon the self-employment tax savings alone.

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Go get last year’s tax return.  How much did you pay in Self-Employment taxes (1040 Line 56)?  Now cut that in half.  You could save at least that much in 2014 by forming an LLC and electing to pay taxes as an S-Corp.

2.  Tax Free Distributions.  Yup.

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This is not talked about much, if at all.   This is the second key reason an S-Corp saves you taxes.  And it is the second consequence (and benefit) of distribution income being a capital gain.

Good-News-292x300The distribution an S-Corp pays you as its owner is tax free (up to a certain point) because of this nifty thing called your Stock Basis.

Your Stock Basis is the amount you’ve invested in your business.  You don’t get taxed on your investment.  You only get taxed on any gain your investment makes.  Make sense?

zero taxesSo, up the the amount you’ve invested in your business in a given year, you can take the same amount in a distribution tax free.

(You read correctly:  Tax Free.  None. Nada.)

If that seems too good to be true, here it is directly from the IRS:  “If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder’s stock basis.”

Your Stock Basis changes every year.  You’re responsible for calculating it, but I recommend you get a tax account to help you calculate it correctly.  The IRS is taking a close look at how owner Stock Basis is calculated.

But, simply for illustration’s sake, let’s take a look at how this works.

To keep with my claim that an S-Corp can save you taxes at even lower income levels, let’s see how it affects a business with $20,000 profit.

Remember, you’ve paid yourself half of that profit as a salary already.  So, we’re just looking at the $10,000 that you’re taking as a distribution.

First, find your Stock Basis.  Let’s assume you formed the LLC and elected to be an S-Corp for the first time this year.

You start with the amount you paid to form the LLC.  (You may also have made other cash contributions as start-up expenses and you’d include those here too.  You do not include the value of any trademarks or copyrightable work.)

Then you add any property you’ve contributed to the LLC since then and the income the LLC earned this year.

This is your stock basis before distribution.  To take a tax free distribution, this amount has to be greater than the distribution.

Amount Paid in to Form LLC/S-Corp (legal fees, filing fee, bank account initial deposit)

$1225

Income Earned in Year 1

+$10,000

Stock Basis Before Distribution

$11,225

Distribution

-$10,000

Stock Basis at Beginning of Year 2

$1225

In the above example, you could take a distribution of up to $11,225 out of your business without being taxed.  So, your distribution of $10,000 is tax-free.

That saves you $1500 (15% income tax on $10,000).  Add that to your self-employment tax savings and you’ve kept $3050 in your pocket that you would have otherwise paid Uncle Sam in taxes.

As your business’s income goes up, the tax savings also go up because the income tax rate is higher.  Let’s look at the example of $114,000 net income.  Remember, again, you’ve take half ($57,000) as salary and paid taxes on that.  Now you’re determining whether the half you’re taking as a distribution is tax-free.

Amount Paid in to Form LLC/S-Corp

$1225

Half Income Earned in Year 1

+$57,000

Stock Basis Before Distribution

$58,225

Distribution

-$57,000

Stock Basis at Beginning of Year 2

$1225

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spcr_10Here, your Stock Basis before distribution is $58,225, which means you can take a distribution up to $58,225 out of the business without being taxed.  So, your $57,000 distribution income is tax-free.

That saves you $14,250 (25% of $57,000).  Add that to your self-employment tax savings ($8721) and you save $22,971.  That’s nearly 2 ½ months of income!

At $144,000 total income (between salary and distribution), you save the highest percentage of your income.  The percentage declines on either side of the $114,000 income mark.

However, you save more in dollars as your distribution income goes up, as long the amount you take a salary is reasonable for your industry and the distribution amount does not exceed your stock basis.  This is how you can save on taxes with an income higher than $114,000.

Let’s look at the example of $228,000 in net income, twice the Social Security tax limit.  You’ve taken half your income ($114,000) as a salary, have paid taxes on it and have not saved any self-employment taxes.  The other $114,000 you’re taking as a distribution.

Amount Paid in to Form LLC/S-Corp

$1225

Income Earned in Year 1

+$114,000

Stock Basis Before Distribution

$115,225

Distribution

-$114,000

Stock Basis at Beginning of Year 2

$1225.

Here, you can take a distribution up to $115, 225 out of your business without being taxed.  So, your distribution of $114,000 is tax free.

That saves you $31,920 (28% income tax on $114,000).  That’s nearly 2 months of income!

The keys to gaining this tax savings legally are:

1.  Pay yourself a reasonable salary.

2.  Calculate your Stock Basis correctly.

I recommend getting an accountant to help you determine those two key things.

But here’s the take away for now:  Electing S-Corp tax status for your business can put up to 2 ½ months of additional income in your pocket.  (Are you sitting up straighter now?)

What are you going to do with your “extra” income this year?

To discuss the specifics of an LLC for your business, make a ½ hour appointment with me here.

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© 2014 Rebecca Prien