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Lev
Lev, Tax Advisor
Category: Tax
Satisfied Customers: 22704
Experience:  Taxes, Immigration, Labor Relations
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W2 vs S-Corp taxation

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Background: Suppose a single individual who is a professional in California who finds a job with an Employer that gives him option of either being a salaried employee or an independent contractor. As an employee of the Company, the individual would not get any benefits like 401k, medical, dental, etc but would be paid $250,000 salary before any withholdings. In this scenario, the company would have to contribute to the employee’s SS and medicare contributions.


 


Alternatively, the individual is given the option of being an independent contractor to the corporation who is given a 1099 in the amount of $250,000 per year. This individual incorporates himself as a Professional Corp and is elected to S-Corporation.


 


Four scenarios:


 


A) Employee receives $250,000 W2 at end of the year. He files personal federal and state taxes. He itemizes a total of $10,000 in deductions. What is his estimated federal, state, medicare, social security, and sdi taxes?


 


B) Independent contractor, who formed an S-Corp and is the sole 100% director, is paid a contract of $250,000 through 1099. He pays out $240,000 to himself as salary and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes?


 


C) Independent contractor, who formed an S-Corp and is the sole 100% director, is paid a contract of $250,000 through 1099. He pays out $120,000 to himself as salary, takes $120,000 in dividends, and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes?


 


D) Independent contractor, who formed an S-Corp and is the sole 100% director/employee, receives a $250,000 salary. He pays out $100,000 to himself as salary, takes $120,000 in dividends, puts $20,000 in 401k, and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes.


 


I’d like to see some sample numbers/calculations of each scenario to get a better idea of the concept of S-Corp. Thanks!

Submitted: 11 months ago.
Category: Tax
Expert:  Lev replied 11 months ago.

Lev :

Hi and welcome to our site!
A) Employee receives $250,000 W2 at end of the year. He files personal federal and state taxes. He itemizes a total of $10,000 in deductions. What is his estimated federal, state, medicare, social security, and sdi taxes?
Assuming Single. no dependents and no other deductions or credits - following are estimated tax liabilities on taxable income $236200


--federal income tax $62400
FICA - social security $7050
FICA Medicare - $4,075
CA income tax $19,500
CA SDI $1008

Lev :

B) Independent contractor, who formed an S-Corp and is the sole 100% director, is paid a contract of $250,000 through 1099. He pays out $240,000 to himself as salary and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes?
On $240,000 wages there will be
--federal income tax $59200
FICA - social security $7050
FICA Medicare - $3840
CA income tax $19,300
CA SDI $1008
S-corporation will pay employment tax on wages
FICA - social security $7050
FICA Medicare - $3840
CA franchise tax - $800

Lev :

C) Independent contractor, who formed an S-Corp and is the sole 100% director, is paid a contract of $250,000 through 1099. He pays out $120,000 to himself as salary, takes $120,000 in dividends, and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes?
The difference would be that income passed from S-corporation (technically these are not dividends) are not subject of employment ides some tax saving. However because there is a maximum on FICA - social security effect will be less on this income level. The Social Security tax rate is 6.2 percent on income under $113,700 through the end of 2013. The Medicare tax rate is 1.45 percent of all income;



--federal income tax $59200 - no difference - because the total income will be same.
FICA - social security $7050 - no difference - that is a max
FICA Medicare - $1920
CA income tax $19,300 - same
CA SDI $1008 - the SDI Withholding Rate is 1%. The SDI taxable wage limit is $100,880 per employee. The maximum to withhold for each employee is $1,008.80.
S-corporation will pay employment tax on wages
FICA - social security $7050
FICA Medicare - $1920
CA franchise tax - $800 - that is minimum tax

Lev :

D) Independent contractor, who formed an S-Corp and is the sole 100% director/employee, receives a $250,000 salary. He pays out $100,000 to himself as salary, takes $120,000 in dividends, puts $20,000 in 401k, and deducts $10,000 in business expenses including payroll. He then files state and federal personal and corporate taxes. What is his estimated federal, state, medicare, social security, and sdi taxes? What are the corporate taxes.
There are two types of contributions to 401k plan - employee elective deferral and employer matching contribution. Employer matching is not subject of FICA and still deductible as business expenses. Employee elective deferral is subject of FICA. I assume that in your example $10k is employee elective deferral and $10 is employer matching contribution.
Both types of contribution are excluded from income taxes - federal and state . However we do not avoid taxes - but only defer the tax liability.
--federal income tax $52500 - reduced because of 401k contribution.
FICA - social security $6800
FICA Medicare - $1600
CA income tax $18,000 - same
CA SDI $1008
S-corporation will pay employment tax on wages
FICA - social security $6800
FICA Medicare - $1600
CA franchise tax - $800 - that is minimum tax.

Customer:

Thank you for your response. I meant to say distribution rather than dividends. So even though in scenario C where $120,000 is in salary and $120,000 distribution, the total income reported for tax purposes is still $240,000?


CA franchise tax - $800 - that is minimum tax [Shouldn’t it be $3600 based on 1.5% of $250,000 in the following examples B-D for the independent contractor]


So I’ve summarized it below:


A: 37.6% taxes, $94,033[$62400 (federal) +$7050 (SS) +$4075 (Medicare) +$19500 (state) + $1008 (SDI)]:


B: 42.0% taxes, $104,888 [$59200 (federal) + $7050(SS) + $3840(Medicare) + $19300 (state) + $1008 (SDI) + $7050 (S-Corp SS) + $3840 (S-Corp Medicare) +$3600 (S-Corp California tax at 1.5%)]:


C: 40.4% taxes, $101,048 [$59200 (federal) + $7050 (SS) + $1920 (Medicare) + $19300 (State) + $1008 (SDI) + $7050 (S-Corp SS) + $1920 (S-Corp Medicare) + $3600 (S-Corp California tax at 1.5%)]


D: 36.7% taxes, $91,908 [$52500 (federal) + $6800 (SS) + $1600 (Medicare) + $18000 (state) + $1008 (SDI) + $6800 (S-Corp SSN) + $1600 (S-Corp Medicare ) +$3600 (S-Corp California tax at 1.5%)]


Scenario E:


Now if the individual takes the contracted job as 1099 but acts as a sole proprietor, it is my understanding that out of an income of $250,000, he will have to pay $14,099 in SS self-employment tax (for $113,700), and $7,230 in Medicare taxes for a total of $21,329.


E. 41.7% taxes, $104,237[$62400 (federal) + $19500 (state) + $1008 (SDI) + $14,099 SS self employment tax + $7,230 in medicare tax]


Conclusion: So, the benefit of the S-Corp structure lies in scenario D where contributions are made to 401k (half between employee and half corp contribution), to decrease the tax burden about 6%. Additional benefits lies in further deductions such as additional business expenses such as meals, car, travel, etc. Additionally, as S-Corp you can maximize 401k contributions up to $51,000 per year for additional benefits? How much can sole proprietor working as independent contractor contribution to a pension/IRA/401k?

Lev :

So even though in scenario C where $120,000 is in salary and $120,000 distribution, the total income reported for tax purposes is still $240,000?
The total income of the individual is $240,000 - that is correct - $120,000 in wages and $120,000 income realized by S-corporation and pasted to the shareholder regardless if that amount actually distributed or not.

Lev :

So, the benefit of the S-Corp structure lies in scenario D where contributions are made to 401k (half between employee and half corp contribution), to decrease the tax burden about 6%. Additional benefits lies in further deductions such as additional business expenses such as meals, car, travel, etc. Additionally, as S-Corp you can maximize 401k contributions up to $51,000 per year for additional benefits? How much can sole proprietor working as independent contractor contribution to a pension/IRA/401k?
The benefits of having S-corporation are based on the fact that income realized by S-corporation and passed to shareholders is NOT subject of employment taxes. In your specific situation - because wages are above maximum limit for FICA social security tax - saving are only on FICA Medicare tax - and are not large.
In additional - savings will be offset additional overhead of having S-corporation - in particular - filing income tax returns, employment tax returns, state returns for the S-corporation. We did not account for these expenses - but they will be. Additional costs will include CA franchise tax - $800 - that is minimum tax.
So - based on your specific circumstances - I do not see any reasons of having S-corporation from tax prospective. There might be other reasons - but not tax saving.
As for contributions into retirement plan - that is not actual "saving" because tax liability is deferred - and will be due when distribution eventually will be taken. So the tax liability is delayed.
You still may have retirement plan as a solo proprietor regardless of S-corporation and defer the tax liability.

Customer: i got my first paycheck (out of 12) as w2 employee and 50% of salary went to taxes (31% federal, 6.2% ss, 1.5% medicare, 10.8% state, 1% sdi). These numbers were a lot higher than projections u calculated. I was told i could get back a good amount when i file my personal taxes. I have only myself as exemption. What would account for these differences. Do i need to modify w4?
Lev :

The large part of your payroll withholding is related to income tax withholding. Withholding is NOT your actual tax liability - your actual tax liability will be determined when you file your income tax return.
The purpose of withholding to cover possible tax liability and it is based on estimates and W4 form you file.

Lev :

So 31% federal and 10.8% state are withholding.
When you will file your federal and state tax returns - most likely you will get a refund.
But that will be based on your total income, filing status, deductions, etc.
Other employment taxes - 6.2% ss, 1.45% Medicare, 1% sdi will not change and there will be no refund.
However - as soon as your wages will reach the maximum for social security tax and SDI - there will not be any withholding for these items.

Customer: So in sample E, is my estimate for self employment tax accurate?
Customer: seems like employer is withholding 31% federal now when he should only be holding 25%, and holding 10% state while he should be withholding 8% now. I understand that i will get it all back at end of year but is there any way i cam get employer to withhold correct amount?
Lev :

Scenario E: Now if the individual takes the contracted job as 1099 but acts as a sole proprietor, it is my understanding that out of an income of $250,000, he will have to pay $14,099 in SS self-employment tax (for $113,700), and $7,230 in Medicare taxes for a total of $21,329.


E. 41.7% taxes, $104,237[$62400 (federal) + $19500 (state) + $1008 (SDI) + $14,099 SS self employment tax + $7,230 in medicare tax]
Self-employment taxes are based on NET self-employment income - after deducting all qualified business expenses. So assuming at least $10,000 is business expenses - $240,000 in net business income will be used to calculate self-employment taxes. My calculator gives $17877 in self-employment tax liability - that corresponds with your calculations.
SDI and CA state income taxes will be about the same will be about teh same.
For federal income tax purposes - you will likely itemize - and will include your state income taxes. So your itemized deduction woudl be at least $20k. You will also deduct half of self-employment taxes
Based on that - your estimated federal income tax liability is expected to be ~$52500.
In additional - your tax returbn would be relatevely simple and will cost less.

Lev :

seems like employer is withholding 31% federal now when he should only be holding 25%, and holding 10% state while he should be withholding 8% now.
Withholding is based on the gross taxable wages, payment schedule and on your W4.
In additional - your employer may choose Percentage Method for Income Tax Withholding - see page 44 in this publication -http://www.irs.gov/pub/irs-pdf/p15.pdf - which may be more than 25%

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 22704
Experience: Taxes, Immigration, Labor Relations
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