For Small Business Owners & the Self-Employed

Insider Secret:

"S" For Savings: The Power of Subchapter S Corporations

Why electing S status for your small business makes more sense than ever

by Alex Goumakos, CPA

The Jobs and Growth Tax Relief Reconciliation Act of 2003 was passed by the House of Representatives and the Senate on May 23, 2003 and signed by the President on May 28.

Like the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Job Creation and Worker Assistance Act of 2002 , the 2003 Act is intended to help stimulate the U.S. economy. Because the revised individual income tax rates are reduced and accelerated, the new tax law is a potentially big tax saver for smaller businesses operating as S corporations.

Consider the following: The principle feature for the 2003 Act is the fact that the individual income tax rates are now lower than ever. The 10 percent and 15 percent tax rates remain the same, but the four higher brackets are cut as follows:

Since the net income from an S corporation flows-through to the tax returns of the individual shareholders, the new lower tax rates will translate into lower personal income taxes on company profits. This is good for news for millions of smaller business owners.

But that's not all..

Cutting the Self-Employment Tax

An S corporation has always been a good vehicle to use to save on the self-employment tax. In fact, the S corporation remains one of the few four-leaf clovers still left in the U.S. Tax code. That's because net income from an S corporation is NOT subject to the self-employment tax.

Small businesses and self-employed individuals who file their taxes using Schedule C know quite well how much the self-employment tax can cost.

A small business can literally save thousands a year by incorporating and electing subchapter S status.

In addition, since net income is NOT subject to the self-employment tax, a small businessperson can pay themselves a salary and take additional monies out without paying a tax on dividends. (Restrictions apply, of course, so please see a tax professional for your own situation).

If structured and implemented properly, a Subchapter S corporation could save you thousands of tax dollars per year. Instead of operating as a sole proprietor, partnership or LLC, you incorporate and elect Subchapter S status with the IRS. (If your state has a high corporate income tax rate, then it would make sense to elect S status with your state as well).

As an employee-shareholder of your S corporation, you pay yourself wages just like you would any other employee. But instead of taking all the profits out through payroll, you take cash distributions called nontaxable dividends.

Nontaxable dividends are called nontaxable, because they aren’t double taxed like the dividends paid to shareholders in a regular C corporation (although beginning in 2003, C corporation dividends aren’t taxed either).

You’re still paying taxes on the net income of your S corporation when you file your personal tax return, but the tax is federal tax and not the self-employment tax. S corporation net income is not subject to the self-employment tax.

Items of Note:

• Salary must be reasonable. You must be diligent when paying yourself a salary as an employee shareholder of an S corporation. The salary must be legitimate and sensible in relation to company profits. In other words, you can’t give yourself an artificially low salary of say $5,000 and then take nontaxable dividends of $50,000.
  
  
• FICA limits: The money you’ll save is reduced once your wages are over the FICA threshold amount (which is currently $87,000 for 2003. Keep in mind that the threshold amount changes each year). If your wages are over the FICA threshold amount, you’ve already paid the maximum “old-age, survivors and disability” portion of the tax. Your only savings of self-employment taxes beyond that point will be on the 2.9% Medicare tax.

Increased Depreciation Deductions

Another key feature of the Jobs and Growth Tax Relief Reconciliation Act of 2003 is the increase in the small business expense allowance for qualifying depreciable property. Here are the details:

Section 179 Deductions
The best part is a huge increase in the Section 179 first year depreciation allowance. The new law quadrupled the allowance—allowing companies to write off up to 100% of the cost of most new and used business assets (other than real estate) in the year it is put into service. Previously, the maximum expense in one year was $25,000. Companies may now write off as much as $100,000 per year in purchases, thus lowering their taxable income by the same amount. And it does not matter whether the company paid cash for the business assets or borrowed to purchase them.

50% Bonus Write Off for New Equipment
The new law also created an accelerated depreciation schedule for some types of property that normally would be written off using standard depreciation tables. For property purchased after May 5, 2003, businesses can choose to claim 50% "bonus" depreciation, which is added on to the normal depreciation write-off for that particular property. For example, if the property normally would be written off over a five year period, the taxpayer could write off 60% of it in the first year - the 50% bonus, plus 20% of the remaining amount.

These changes are a potential huge tax savings, especially for businesses contemplating purchasing new equipment, machinery or other depreciable assets.

Because of these and other favorable tax rules, the S corporation remains a potent tax savings vehicle. The Jobs and Growth Tax Relief Reconciliation Act of 2003 only made a good thing better. Talk to your CPA or other tax advisor to see if you too can take advantage of the benefits of using an S corp.