Being taxed as an S corporation offers some of the most tax advantages for high-earning real estate professionals. Many people know the benefits of an S corporation include corporate financial liability protection but perhaps the biggest advantage is the reduction of payroll taxes.
Filing your taxes as an S corporation allows you to have all the same liability advantages as any other limited liability structure but it also allows for pass through treatment for federal tax purposes. The corporation’s income, expense and tax credits passed through from the company to its owner.
Self-employment taxes are your share of Social Security and Medicare taxes that you pay. The wage limit for 2019 for maximum Social Security withholding is $132,900 meaning that you pay for the Social Security portion of self-employment tax in 2019 is 12.4% of $132,900 which equals $16,479.60. Additionally there’s another 2.9% on top of that that goes towards Medicare and there is no income limitation on that. You are allowed to deduct a portion of your self-employment tax on your 1040.
The biggest benefit of an S corporation is that there is a reduction of payroll taxes for the owners that they would not otherwise be able to take. To take advantage of this a business owner must elect to be taxed as an S corporation by filing form 2553 with the IRS. It is highly recommended that you hire a competent accountant to complete form 2553 on your behalf. A mistake made on this form is very costly and can possibly even be irreversible.
Example: Tom is a successful real estate agent and had a net income of $100,000 from Real Estate activities. If Tom operates as a sole proprietorship his self-employment tax alone would be $14,130. On the other hand is concrete an S corporation and pays himself $40,000 salary and takes distributions of $60,000 he only pays self-employment tax on his salary. In this example self-employment tax equals $6,930. As an S corporation Tom would save himself at $7,200 per year on an income of $100,000.
In our example here Tom’s total income is exactly the same $100,000. The difference lies in the taxation laws of a sole proprietor and an S corporation. As a sole proprietor all income is taxed the same and subject to self-employment tax. As an owner of an S corporation, Tom can take a salary and receive an income distribution. The distribution portion of Tom’s income is not subject to self-employment tax.
To take full advantage of the S corporation status the IRS requires that the owner must pay himself (herself) a “reasonable salary” and that salary is subject to normal taxes on a W2 just like any other employee. There is no crystal clear definition of “reasonable” in the Internal Revenue Manual. The good news is the profits the owner receives on top of the salary can be taken as distributions and are not subject to self-employment tax. This strategy can save the owner a lot of money. The more you make the more you can save.
As an S corporation your business will report your income from that business two different methods: First you will receive a W-2 for the reasonable salary you have paid yourself, secondly the distributions you take that are not subject to self-employment tax will be reported on form K-1. The K-1 will flow through from your S-corporation tax return (1120S) to your personal tax return (1040).
So what’s the catch? Well for the most part it’s going to be paperwork. You will need to establish an S corporation file IRS form 2553 with the IRS and get an EIN number assigned to your corporation. Websites such as legalzoom.com can walk you through the process of creating your own S corporation. However, it is highly recommended that you seek a professional to assist you with this. Additionally you can hire a payroll company that will help you complete your payroll filings for you ,file your W-2s, and complete all your IRS state and local payroll tax filings as necessary. An S corporation you will also have an annual fee payable to the Secretary of State. Here in California that annual fee is $800. Each year you will have to file a separate corporate income tax return on form 1120s. This income tax return is more complicated than a personal income tax return and once again it is recommended that you have an accountant prepare it for you rather than self-preparing that corporate return yourself.
Example: Tom, our successful real or walked into our office with last year’s income tax return and wanted to discuss a strategy to reduce his total tax liability to the IRS. After a quick review of last year’s income tax return we noticed that Tom paid over $14,000 in self-employment taxes. This is in addition to his ordinary income tax. We suggested to Tom that he create an S corporation and pay himself a reasonable salary. Tom would still be obligated to pay self-employment taxes on his salary. However the amount the Tom took is a distribution would not be subject to self-employment tax, only income tax. We determined that Tom could save over $7,000 per year by implementing this strategy.
Tom was eager to get started. First we created Tom Real Estate Pro Inc. then we referred Tom to a local Payroll Company that charges a small fee each time he pays himself a salary. At the end of the year Tom will have to file his regular personal income tax return and a separate corporate income tax return. Each year Tom pays approximately $1,100 for his corporate income tax return. Additionally, he pays an $800 fee to the California Secretary of State. Tom also pays approximately $500 a year to the payroll company to file his W-2s and report all of his IRS, state, and local tax paperwork to the appropriate tax agencies. In total, Tom pays approximately $2,400 a year to save $7,000 self-employment taxes.
The process of creating the S-Corporation and the annual corporate formalities are absolutely necessary to be able to reduce your tax liability through the reduction of self-employment taxes.