S Corps are the hip new kid on the block when it comes to legal entities for freelancers. Many freelancers opt to own and operate their business in the form of an S Corp (also called a Subchapter S Corp), and reap the sweet tax savings that comes along with an S Corp.
Put simply, when your business is an S Corp (a.k.a. S Corp), you become its employee for tax purposes. Most S Corps only have one owner (shareholder) who is also the only employee.
Thinking it might be time to get to know the cool kid everyone’s talking about? Read on to learn about some of the tax benefits of running an S Corp and how to pay yourself a salary from an S Corp.
Just keep in mind that, while we’ve made every effort to ensure this information is up-to-date and accurate, it doesn’t constitute legal advice or tax advice, and it shouldn’t be considered a substitute for legal or tax advice. It’s always best to consult with an experienced lawyer or tax expert if you need guidance for your freelance business.
How Does Forming an S Corp Help You Save on Taxes?
Everyone wants to save money when it comes to taxes, so it should come as no surprise that a lot of freelancers turn to S Corps when they’re deciding between different business entities.
How, exactly, do you save money?
Well, you don’t have to pay payroll taxes on distributions from your S Corp. Distributions are the earnings and profits that pass through the corporation to you as an owner (shareholder). Keep in mind that distributions are not your employee wages.
Payroll taxes consist of:
- 12.4% Social Security tax, up to an annual ceiling (in 2019, that ceiling is $132,900)
- 2.9% Medicare tax on all employee wages
Combine those two tax rates and you get a 15.3% tax, which really adds up at tax time.
With an S Corp, the larger your shareholder distribution, the less payroll tax you’ll pay on your business profits. Nice, right?
Let’s do an example:
Let’s say that Mel runs a Bitcoin mining business, and earns $100,000 in profit this year. As a sole proprietorship, he’ll pay payroll taxes on his entire profit.
But let’s say he operates his business as an S Corp and pays himself a salary of $50,000 while taking $50,000 as a shareholder distribution. In this scenario, he’ll only pay payroll tax on his $50,000 salary. And that means he saves thousands in payroll taxes each year!
This sounds amazing! But, why would I want to take an employee salary? Can’t I just pay myself in distributions?
Not really. While you wouldn’t owe any Social Security and Medicare taxes, you would be breaking a major rule about S Corps.
A reasonable salary is a must
The IRS requires S Corp shareholder-employees to pay themselves a reasonable employee salary, which means at least what other businesses pay for similar services.
And if the IRS finds out that you tried to evade payroll taxes by disguising employee salary as corporate distributions, bad things can happen. Basically, the IRS can recharacterize your distributions as salary and require payment of back payroll taxes and penalties. These can include payroll tax penalties of up to 100%, plus negligence penalties. See? Very bad things.
Also, even though no tax is withheld from a shareholder distribution, this doesn’t mean that these distributions are tax free. S Corp shareholders still must pay income tax on their distributions.
And if the total income tax you’ll owe on your distributions is $500 or more, you can’t wait until April 15 to pay all of the tax that’s due. Instead, you need to make estimated tax payments every quarter.
Bad at sticking to estimated tax payments? You can also increase the withholding from your employee salary to cover those payments.
Here’s a real-life example about the importance of paying yourself a reasonable salary:
A CPA who incorporated his practice took a $24,000 annual salary from his S Corp and received $220,000 in distributions that were free of payroll taxes.
The IRS said that his salary was unreasonably low, and that $175,000 of the distributions should be treated as wages subject to payroll taxes.
The Tax Court upheld the IRS’s power to recharacterize the distributions as wages subject to payroll tax. (Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d.)
How Much to Pay Yourself from Your S Corp
Now that you understand the basics of taxation when you operate an S Corp, let’s get into how to pay yourself so that you can do things the right way.
How Much Salary Is Reasonable for You?
It’s up to you to decide how much employee salary to pay yourself. Which might sound exciting, except you have to make sure it jives with the IRS rules.
Here’s a general rule to follow: reasonable pay is the amount that similar enterprises would pay for the same, or similar, services.
In other words, what do other workers in similar roles to yours get paid by their employers? But it’s also important to consider how the IRS would see things.
Below are some of the factors that the IRS considers. Keep these in mind as think through your reasonable salary.
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- Use of a formula to determine compensation
Also, the IRS states that the key to establishing reasonable compensation is determining what the shareholder-employee does for the S Corp.
Translation: the IRS looks at the source of your business’s income, and there are three major sources: your services as an employee; services by other non-shareholder employees; and capital and equipment.
- If the majority of your business’s gross income and profits come from your services as an employee, the IRS says most of the profit should be distributed in the form of employee salary and bonus.
- If most of the income comes from services by other non-shareholder employees and/or capital and equipment, then it’s reasonable for you to receive shareholder distributions, along with employee salary.
After examining all of the circumstances, the IRS establishes a range of reasonable salaries, from low to high.
In one case, the IRS concluded that a reasonable salary for an Arkansas certified public accountant was $45,000-49,000 (the IRS used salary information from a large financial services recruiting firm to determine what was reasonable).
The accountant, in that case, had paid himself no salary and received $83,000 in corporate distribution. This was obviously a problem, so you want to avoid making the same mistake. (Barron v. Comm’r, T.C. Summ. 2001-10.)
Decide How Much to Pay Yourself
What should you keep in mind when deciding how much to pay yourself?
First, consider that your total employee compensation includes salary, bonuses, and any health insurance premiums paid by the corporation and listed as wages on your W-2.
Remember: not paying yourself any salary while your business is making money is a red flag for an IRS audit.
Pay yourself some employee compensation, but also bear in mind that paying yourself minimum wage likely won’t be considered reasonable either.
If you’re concerned about choosing the right amount of compensation, don’t worry.
Here’s a simple strategy that you can try, and it’s called the 60/40 rule:
- Pay 60% of your business income to yourself in the form of employee salary
- Pay yourself 40% of your business income in the form of distributions
Note: This isn’t an IRS rule and has never been officially approved by the IRS. Rather, it’s a rule of thumb that’s used by many accountants. And, even though it’s unlikely that the IRS would complain if you use this formula, there aren’t any guarantees.
Want to take a more sophisticated approach? Well, you could base your salary on what employees performing the same, or similar, jobs are being paid. But you need to figure out those numbers first.
- A lot of employee pay stats are readily available, and one free source of information is the Bureau of Labor Statistics. There, you’ll find highly detailed salary information for 800 companies.
- You can even find salary information on sites like Glassdoor, Salary, and Payscale.
- Or, you could purchase a compensation analysis online from RCReports.
What If You Wear Multiple Hats?
When you’re running your own business, there are a lot of things that need to get done every day. So it’s no wonder that many small business owners end up performing multiple jobs.
For example, the owner of a one-person web development company might spend 75% of their time doing actual web development, and 25% of the time doing admin and marketing work.
If this sounds like you, you can check out salary information for every type of job that you do, and then combine those rates. But beware: this could get complicated. It’s easier to just look for the closest comparison that you can find.
Making Adjustments to Figure Out Your Ideal Salary
Let’s say that you’re searching through statistics and you’ve found a salary or wage comparison. The next step is to make reasonable adjustments based on the differences between your business and the average business.
For example, you might adjust the salary downward if:
- Your business is less profitable than other businesses in your area
- You don’t work full-time (that’s less than 2,080 hours annually)
- Factors other than your personal efforts, such as the types of assets you own, led to the success of your business
Once you decide on your employee compensation, make it a point to document how you arrived at that amount. Add this information to your corporate minutes, and keep copies of the salary stats that you used to set your salary.
The IRS won’t object if your S Corp pays you nothing if your business is earning little to no income. However, when your S Corp starts making money, the first thing you need to do is pay yourself reasonable employee compensation.
Then, if there’s any money leftover after that, you can distribute it to yourself as shareholder distributions that are free of payroll taxes.
Tip: The IRS is most likely to audit you if you’re taking shareholder distributions without a salary.
Ready for another example?
Athena is a freelance technical writer who formed an S Corp. She is the corporation’s sole shareholder and employee. Her business profit is $120,000 per year. The Bureau of Labor Statistics shows that the median salary for technical writers is $70,930.
Athena’s S Corp pay her $70,000 in employee salary and bonus, and a $50,000 shareholder distribution, saving her $7,650 in payroll taxes.
How to Make Salary Payments to Yourself
After taking the time to figure out how much you should be earning, it’s time to set up a system for paying yourself.
When you incorporate your business and create an S Corp, you become its employee if you perform more than minor services for it. And, for tax and other legal purposes, you must be treated the same as any other employee.
What does it mean to be treated like any other employee?
- Your corporation must pay half of your payroll taxes from its own funds, withhold the other half from your pay, and send the entire amount to the IRS.
- Your corporation must send a W-2 form to the IRS every year, showing how much you were paid. It also has to file an annual employment tax return.
- Your corporation must pay unemployment taxes on your behalf. The federal unemployment tax (FUTA) is 6% of your first $7,000 in pay. In some states, you’ll be exempt from state unemployment tax, while other states require that you pay state unemployment tax too.
- Your state might require your corporation to provide you with workers’ compensation coverage. Check with your insurance agent or your state’s workers’ compensation agency.
- Some states, such as California and New Jersey, also impose a state disability insurance (SDI) payroll tax. However, one-owner corporations can opt-out of SDI in California.
A few other things to keep in mind:
It’s up to you to determine how often you want to pay yourself an employee salary. It might be once or twice a month, or less often.
Some S Corp owners only pay themselves a salary once annually, at the end of the year. But it’s wise to get paid at least quarterly since your business might have to make quarterly payroll and income tax deposits, as well as file quarterly employment tax returns.
Also, you don’t have to pay yourself the same employee salary every payday. As an example, you could pay yourself a relatively small salary every quarter and then pay yourself a substantial year-end bonus.
And if you ever need more money, you can take a shareholder distribution at any time. Remember, no taxes are withheld from these distributions, and it’s easier to take a distribution than constantly changing your employee salary (if you did that, you’d have to recalculate federal payroll tax withholding and other tax obligations with every change).
Using a Payroll Service
Real talk: complying with all of the tax requirements, as well as all of the other legal requirements that come with running a business, can be super complicated. Not to mention confusing!
To keep things simple, many freelancers opt to hire a payroll tax service or accountant who can help by doing all of the hard work for them.
There are national online-based payroll tax services, like Gusto, you can try and also many small, locally-based services.
You can even consider using a platform like Collective, which not only organizes and maintains your S Corp but also maximizes your tax savings by helping you figure out exactly how much to pay yourself.
Put simply, Collective helps take the guesswork out of S Corp taxation so that you can save more money.
After signing up with Collective, you’ll gain access to a team of experts, including a CPA, who helps you with all the scary tax and legal stuff, like calculating paychecks to submitting quarterly tax payments.
Reporting Your Salary on Your Taxes
Just like any other employee would, you have to report your salary on your taxes.
Your S Corp will send you a W-2 form by January 31 each year, showing your total employee wages for the previous year.
Then, you simply report that amount as income on your Form 1040 when filing your tax returns.
Since your shareholder distributions from your S Corp aren’t wages, they aren’t included in your W-2.
Instead, your S Corp files IRS Form 1120S, U.S. Income Tax Return for an S Corporation. This form is an information return that reports your business’s income, deductions, profits, losses, and tax credits for the year. It also includes Schedule K-1, which is completed for each shareholder.
- Every shareholder must be provided with a Schedule K-1 by March 15. However, the deadline is extended to September 15 if you file an extension for your corporate tax return.
- Schedule K-1 shows each shareholder’s share of the corporation’s income or loss. If you’re the only shareholder, your share will be 100%.
Any income that your business had at the end of the year after deducting its expenses, including salaries and other employee compensation, passes through the corporation and is taxed on your individual tax return.
Remember that your S Corp doesn’t pay any tax itself. All of the profits that it earns passes through the business to the shareholders.
Then, you’ll report your share of the business’s net profit or loss (as shown on Schedule K-1) on your individual tax return (Form 1040)..
Tip: It’s best to have a tax pro complete your corporation’s Form 1020S and Schedule K-1 since these forms are complex.
Get Paid What You Deserve for Your Hard Work!
Running a freelance business as an S Corp can be a smart way to save some serious money when it comes to taxes. But, with great tax savings comes great responsibility– especially when it comes to paying yourself.
Ultimately you want to make sure that you’re paying yourself the amount that you deserve, while also meeting all tax requirements. Once you’ve got that part down, you can go back to doing what you do best- killing it in your business and getting paid what you’re worth.
Stephen Fishman has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.