S-Corporations vs. LLC: Income Tax Savings Benefits

I am the President and CEO of a uni-national corporation. A one-person S-corporation, to be exact. I chose this over an LLC for a variety of reasons (most of which I don’t remember anymore), but one of them was – what else? – to save some money. I wrote a relatively wordy post a few years back on Forming An S-Corporation To Reduce Self-Employment Taxes. But I just read this e-mail from MyCorporation* that has a concise example with a nifty graphic thrown in:

In an S-Corporation, only earnings paid to an owner as salary is subject to payroll taxes. Any money left in the business for reinvestment or distributed to the shareholder as a dividend is not subject to self-employment tax.

Maria is a sole proprietor bringing in sales of $90,000. After she pays her costs & expenses, her profit is $60,000. As a sole proprietor, she is required to pay self- employment tax of 15.3% on this entire $60K of profit, which equates to $9,180.

Now, let’s assume Maria formed an S-Corporation for her business, and chooses to pay herself $35K for the year in salary, and take the remaining $25K of profit through a distribution. She still earns the same $60K in profit. But, let’s look at the tax situation. Because corporations only pay Social Security & Medicare taxes on salaries, she’s only liable for $5,355, saving over $3,800 in taxes!

If you have a single-person LLC, the tax situation is usually very similar to that of a sole-proprietorship. (I should add that in some states you can also choose to have the LLC taxed as an S-Corporation. I would consult a local attorney for more details on this.) Now, the salary has to be “reasonable” based on the compensation of similar work elsewhere, so don’t get too crazy with this.

The catch? As an employer, the S-Corporation has to pay unemployment taxes. The exact rate varies from state to state, but the federal minimum is about $450 per year if your annual income is at least $7,000. However, as both the employer and employee, it is very difficult for me to actually “lay myself off” and claim unemployment benefits. So this fact cuts slightly into potential tax savings.

* I actually used LegalZoom to file my incorporation papers, which is their main competitor. I don’t really remember any big differences between them, but was happy with my Legalzoom experience.

Recommended Book On Tax Deductions For Home Businesses and Freelancers

I got a lot of positive responses from my self-employed tax-related post yesterday. I’ll be happy to continue sharing more of my experiences, but given the complexity of tax issues I wanted to throw out a book recommendation – Home Business Tax Deductions: Keep What You Earn by Fishman.

This is my hands-down favorite book on tax deductions for those with home-based businesses. It has saved me many times the $20 cover cost. I checked this book out from the library first as well, but ordered it online within a few days. I’ve read several other tax books and they are either (1) too light on the details, or (2) too aggressive and bordering on both the unethical and illegal. This book provides a good summary of the IRS code, and practical ways to substantiate deductions that you qualify for.

The primary benefit of a good tax book is that it gives you the confidence to take the deductions that you deserve and qualify for. Many times people simply don’t try because they are afraid of the Big Bad Audit. Instead, I am now confident that I followed the rules and can pass an IRS inspection. Remember the difference between tax avoidance and tax evasion:

Tax Avoidance is perfectly legal. The courts have stated clearly that you have no duty to pay more taxes that what is minimally required by law. You have every right to take all legitimate deductions and also to structure your business to minimize taxes.

Tax Evasion is a crime. This involves fraud, misreporting income, or taking deductions that you do not qualify for.

(Is it tacky to quote yourself?) Even if you have an accountant, I think it is good to understand a bit of what is going on.

Self-Employed or Freelance? Maximize Your Business Mileage Tax Deduction

An important part of maximizing the profit from your own business – no matter how small – is to be smart with taxes. If you are running a side business on top of your day job, you may be paying around 50 cents of every dollar made towards taxes. This means, that for every $1 in tax deductions you find, you are keeping an extra 50 cents in your pocket.

One of the more tedious tax deductions for self-employed folks is deducting transportation expenses. The simplest way to claim this deduction for those without vehicles used solely for business is to track the number of miles driven for business use. (You can also record actual automobile expenses like gas and maintenance, and pro-rate.) The IRS just announced yesterday that the standard mileage deduction will be 58.5 cents/mile for all business miles driven for the last half of 2008, up from 50.5 cents/mile.

From above, this means that for every single business mile you deduct, you might save around 29 cents. Deducting just 100 miles per month would save you around $350 over a year. Put another way, not tracking 100 miles a month will lose you $350 a year. There are many complex rules for what constitutes eligible business travel, but it can be worth asking your accountant or reading up. Here are some examples:

  • Driving to the office supply store to make business purchases.
  • Driving from your home office to an external location meet a client.
  • Driving to the bank to deposit checks or make other business transactions.
  • Driving to pick up mail from your UPS Store or P.O. Box.
  • Driving to the post office to send business-related mail or buy stamps.

Many times, you might do this stuff without a second thought. But with gas costs so high, I would argue that we need to recoup whatever we can get. Trust me, these miles can add up quickly!

How do I properly track such mileage? At most office supply stores you can buy a mileage logbook. Or, simply start up a spreadsheet program and create these columns: date, purpose (bank, etc.), odometer start value, odometer stop value. Print it out, slap it on a clipboard, and stick it permanently in your car like I do. Record everything immediately, it should take seconds; you can add up the miles later. (Added: mileage log template for Excel)

What about driving from my self-employed home office to my day job with another employer? Nope, although it would be sweet to deduct such commuting costs, this is not qualified business travel. However, if you have a second site for your own business like a storefront, travel to/from your home office to/from that site can be deductible.

What if my UPS mailbox is next to my day job? Here’s where things get a bit fuzzy. You definitely aren’t allowed to deduct personal trips. But let’s say the supermarket is right next to your business bank. Since you’re already there, isn’t doing some grocery shopping the the eco-friendly thing to do? From my non-official understanding, you would need to prove that your trip to the bank is necessary and the primary reason for the trip, and not just an excuse to go to the supermarket. Making an actual deposit transaction would seem to be sufficient in that regard.

But if you are trying to say that your “business bank” is 30 miles away from your home office and just happens to be the one next door to your 9-5 job, then that may be much harder to justify. It is truly necessary to use that branch?

There’s more… You may also be able deduct mileage driven for charity, medical treatment, job searches, and moving.

References: IRS Publications 535, 463, and 529

Fidelity Self-Employed 401k Account Review

I’ve mentioned several times I have a Self-Employed 401k account. It’s a somewhat unique thing, so here’s a little bit more about it.

What’s a Self-Employed 401(k) and who’s eligible?
A Self-Employed 401(k) is a tax-advantaged 401(k) retirement account that is available to self-employed individuals or business owners with no employees other than a spouse, including sole proprietors, partnerships, corporations, and S-corporations. It is also referred to as an Individual 401(k) or a Solo 401(k). You can even get them in Traditional or Roth versions.

For more details, see these other posts:

I chose a Solo 401k over other options like SEP-IRA due to the increased contribution limits for those with relatively low self-employed incomes. I ended up picking Fidelity Investments as my plan administrator, and here are my experiences after using it for the last year:

Application Process
It’s been a while, so I don’t have a rundown of dates or anything, but I remember the application being a bit long, but very straightforward. You can either print the forms out online, or have them mail you a nicely bound copy. I mailed it in, they set it up, and I had my own Solo 401k. No hassles.

Account Fees
There were no setup fees, no maintenance fees, no minimum balance requirements, no annual fees. I only thing I’ve ever paid is for the expense ratios in the mutual funds I bought. As you’ll see below, that’s barely added up to $20 so far!

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