Independent contractors and real estate investors love S corporations (S corps). That's because an S corp provides significant advantages over sole proprietorships or traditional corporations—both in terms of limited liability and reduced taxation.
An S corp is not a separate type of business entity. Rather, it is a designated tax status for businesses that meet these criteria:
An S corp otherwise follows all the other requirements of a traditional corporation. It has a board of directors, drafts corporate bylaws, has shareholder meetings, and keeps meeting minutes of company meetings.
Compared to sole proprietorships and traditional corporations, S corps have several benefits, including lower taxes and reduced legal liability.
To receive these benefits, the corporation must register as an S corp. You'll do this by filing IRS Form 2553. This form essentially states that the corporation meets the requirements listed above and that all shareholders consent to the registration.
If you operate as a sole proprietorship and get sued, all of your personal assets are at risk. For example, assume you do business as a sole proprietorship and own $200,000 worth of real estate at 100 North Street. You also have $6.2 million in other personal assets.
If you get sued as a sole proprietor, all of your assets ($200,000 + $6.2 million = $6.4 million) could be subjected to liability. However, assuming your S corp is in good standing and complies with all legal requirements, if someone sues you for an issue related to the property at 100 North Street, your liability could be limited to $200,000.
S corps have huge taxation advantages because business income passes directly to the shareholders. There’s no separate corporate tax—only the shareholders are taxed. This is known as the “pass-through” concept and is a distinct advantage over sole proprietorships and traditional corporations.
For the independent contractor or self-employed real estate investor, this means that you are the owner and employee of the company. As an employee, you pay yourself a reasonable salary and are taxed on that - while the S corp itself pays no taxes.
Before discussing the advantages of an S corp over a sole proprietorship or traditional corporation, you need to understand what constitutes a reasonable salary.
An S corps’ shareholder-employee must be paid a reasonable salary as compensation. It is treated as employee wages for tax purposes. The IRS requires the salary to be reasonable because it pays the self-employment tax (i.e., it funds Social Security and Medicare). Check out our article, Using Your S Corp: Payroll Taxes for the skinny.
It is critical to get the reasonable salary right because the IRS will be taking a close look—trust us on this. Fortunately, the IRS has published factors to consider when determining the appropriateness of a salary. IRS Form FS-2008-25 provides these factors, listed verbatim here:
There are other factors as well, but they only become relevant when the S corp has multiple employees. For the individually-owned S corp, which is typical of many independent contractors and real estate investors, these do not apply.
There are many rules of thumb for estimating reasonable compensation. Presented in terms of salary per total business profits, they range from 33:67 to 50:50 to 60:40. However, instead of relying on generic guesses, we recommend hiring a certified public accountant or lawyer to estimate the percentage of business profits devoted to salary.
Here’s are examples of how S corp taxation works compared to sole proprietorships and traditional corporations.
Let’s assume you are an independent contractor or a real estate investor with a sole proprietorship. Last year, you made $100,000 in profits. As a sole proprietor, you pay a 15.3 percent self-employment tax, or $15,300, in taxes.
Now let’s assume that you have an S corp, and you’ve worked with your accountant or lawyer to arrive at a reasonable salary of $60,000. In this case, because the S corp profits themselves are not taxable, you would only pay the self-employment tax on your salary. That would be $60,000 x 15.3 percent = $9,180. So, being structured as a corporation with S corp registration, instead of a sole proprietorship, would save you $15,300 - $9,180 = $6,120 in federal taxes.
A traditional C corporation not registered as an S corp would pay federal taxes on both the corporation’s profits and the employees’ salaries. This likely would be significantly more than the amount paid solely by an S corp employee.
To learn more, check out our article Series LLCs and S Corporations: Which Is Best For Your Business?
If you are an independent contractor or real estate investor, consider structuring your business as a corporation registered with the IRS as an S corp. Our legal experts at Royal Legal Solutions can discuss your options, including the calculation of a reasonable salary under an S corp ... So don't hesitate to reach out if you have any questions about this strategy!
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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