Many freelancers opt to own and operate their business in the form of an S corporation (also called a Subchapter S corporation), as doing so allows them to reap some helpful tax savings.
Put simply, when your business is an S corporation (a.k.a. S corp), you become its employee for tax purposes. Most S corporations, though, only have one owner (shareholder) who is also the only employee.
Below, we cover some of the tax benefits of running an S corp, as well as what the process is for paying yourself a salary from your business. 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?
- Calculating How Much to Pay Yourself from Your S Corporation
- Here’s How to Make Salary Payments to Yourself
- Reporting Your Salary on Your Taxes
- Reporting S Corporation Shareholder Distributions
- Get Paid What You Deserve for Your Hard Work
Everyone wants to save money when it comes to taxes, so it should come as no surprise that a lot of freelancers turn to the S corp option when they’re deciding between the various business entities that are available.
How, exactly, can you save money? Well, you don’t have to pay payroll taxes on distributions from your S corporation—that is, on earnings and profits that pass through the corporation to you as an owner (shareholder), not as an employee in compensation for your services.
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. They really do add up! But, the larger your shareholder distribution, the less payroll tax you’ll pay on your business profits. Nice, right?
Here’s an example to help clarify:
Let’s say that Mel runs a Bitcoin mining business, and he earned $100,000 in profit this year. If he operates as a sole proprietorship, he’d have to pay payroll taxes on his entire profit. Ouch! On the other hand, if he operates his business as an S corp, and if he paid himself a salary of $50,000 while taking $50,000 as a shareholder distribution, he’d pay payroll tax only on his $50,000 salary. And that means that he’d save thousands in payroll taxes!
Okay, but what if you took no employee salary at all and you paid yourself only with distributions? Well, in that case, you wouldn’t owe any Social Security and Medicare taxes at all. But, not so fast, as this isn’t allowed.
The IRS requires S corporation shareholder-employees to pay themselves a reasonable employee salary, which means at least what other businesses pay for similar services. And if the IRS concludes that an S corp owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, they can recharacterize the 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. Yikes!
Also, even though no tax is withheld from a shareholder distribution, this doesn’t mean that these distributions are free of tax. That’s because S corporation shareholders must pay income tax on their distributions. And if the total income tax you must pay 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 must pay the tax due every quarter in the form of estimated taxes. Alternatively, you can increase the withholding from your employee salary.
Here’s a real-life example to help illustrate this point before we move on:
A CPA who incorporated his practice took a $24,000 annual salary from his S corporation 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.)
Now that you understand the basics of taxation when you operate an S corporation, let’s get into how to go about paying yourself so that you can do things the right way.
First, Ask: How Much Salary Is Reasonable for You?
It’s up to you to decide how much employee salary to pay yourself. No, really, it is! But there is 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 and courts consider. Keep these in mind as you work on figuring out what a reasonable salary would be for yourself.
- 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 did 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. For example, 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.)
Next, Decide: How Much Should You Pay Yourself?
What should you keep in mind as you decide how much to pay yourself? Well, you should 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.
Or, you could purchase a compensation analysis online from RCReports. Easy enough, right?
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 the other 25% of the time performing administrative work or completing marketing tasks.
If this is the case with you, you can check out salary information for every type of job that you do, and then simply combine those rates. Beware that this could get complicated, so it’s easier to just look for the closest comparison that you can find.
Make 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 would be 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 relied on to come to your conclusion.
Note: 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 to further clear up what we mean?
Steve is a freelance technical writer who has formed an S corporation. He is the corporation’s sole shareholder and employee. His business profit is $120,000 per year. The Bureau of Labor Statistics shows that the median salary for technical writers is $70,930. Steve has his S corp pay him $70,000 in employee salary and bonus, and he has his corporation pay him a $50,000 shareholder distribution, saving him $7,650 in payroll taxes. See what we meant when we said you could save thousands in taxes?
After taking the time to figure out how much you should be earning, it’s time to set up a system in which you can make salary payments to yourself.
When you incorporate your business to create your S corporation, 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 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, as your business might have to make quarterly payroll tax and income tax deposits, as well as file quarterly employment tax returns.
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.
If you ever need more money, you can take a shareholder distribution from your corporation at any time. Remember, no taxes are withheld from these distributions, and this can be easier than continually changing your employee salary (if you did that, you’d have to recalculate federal payroll tax withholding and other tax obligations with every change).
Consider Hiring a Payroll Service
Let’s face it: 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! For this reason, many small business owners 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, such as Gusto, but there are also many small, locally based services that you can try as well. You can even consider using the services of a platform like Hyke to not only organize and maintain your S corp, but also save on your taxes while reaping the benefits of payroll support.
Put simply, Hyke helps take the guesswork out of S corp taxation so that you can save more money. After signing up, you’ll gain access to a team of experts, including a CPA, who are willing to help you at every step with everything from calculating paychecks to submitting quarterly tax payments. Plus, with year-round tax advice, you can rest easy and focus more on doing what you love.
Just like any other employee would, you have to report your salary on your taxes.
Your S corp will provide you with a W-2 form by January 31 each year, and this will show 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. Pretty straightforward, right?
What about reporting your distributions? Well, your shareholder distributions from your S corp aren’t wages, so 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 displays the corporation’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 an extension to file the corporation’s tax return is filed.
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 all expenses, including salaries and other employee compensation, passes through the corporation and is taxed on your individual tax return.
Remember that your S corporation doesn’t pay any tax itself. All of the profit that it earns passes through the corporation to the shareholders. You’ll report, on your individual tax return (Form 1040), your share of the business’s net profit or loss as shown on Schedule K-1.
Tip: It’s best to have a tax pro complete your corporation’s Form 1020S and Schedule K-1, as these forms are complex.
Running a freelance business as an S corporation can be a smart way to save some money when it comes to the taxes that you owe. But there are quite a few things to consider to be sure you’re paying yourself the amount that you deserve, while also meeting all tax requirements. Hopefully, the information above has helped clarify this topic so you can run your business with greater confidence, and so you can take advantage of all of the benefits of operating an S corp of your very own.
Stephen 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.