The long story short is that you save a bit on self-employment taxes by using an S corp rather than using Schedule C. There are exceptions, but for most self-employed folks, an S corp will save you money on taxes.
When you report your independent contractor income on Schedule C, it’s all subject to self-employment taxes.
When you have an S corporation, you’re only paying self-employment taxes on the amount of your income that you take out as wages. (Of course, in a wage context, it’s not called “self-employment taxes”; it’s called “Social Security withholding” and “Medicare withholding”; but it’s essentially the same thing).
Let’s take an example. John Doe is an independent contractor who has profit of $100,000 in a given tax year. If he reports his entire income on Schedule C, he will pay $15,000 in self-employment taxes.
Now let’s say that instead of reporting on Schedule C, John Doe set up an S corp and took $40,000 as salary and $60,000 as a distribution. Only the $40,000 would be subject to Social Security and Medicare withholding, so he would only be paying $40,000 x 15% = $6,000 for the equivalent of self-employment taxes by using an S corp. And yes, the IRS has rules in place that you must pay yourself a “reasonable salary,” otherwise no S corp owner would take cash out of his or her business in the form of salary.
$15,000 – $6,000 = $9,000. So you’re getting $9,000 of tax savings simply by using an S corp. Sure, there are other complexities, such as the increased administrative costs of setting up an S corp (e.g., payroll), having to pay a CPA for another tax filing, the fact that on your 1040 you can deduct 50% of self-employment taxes paid, various state complexities, etc., but the fact remains at the end of the day that at a certain level of income, a self-employed person / independent contractor will save some money by using an S corp rather than reporting on Schedule C.
Of course, the exact answer of what’s right for you depends on your individual tax situation. This post is simply informational in nature and not intended to be used as tax advice or to avoid tax penalties. You should consult with your independent tax advisor to go over your specific situation.
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