Dear Jennifer,

In addition to income tax, owners of sole proprietorships and other self-employed individuals pay a self-employment tax on the net taxable income from self-employment. The self-employment tax rate is 15.3%. This rate consists of 12.4% for social security and 2.9% for Medicare.*

In an S corp, owner-officers who perform services on behalf of the corporation are considered employees. Only their salaries are subject to employment tax; shareholder distributions of profit are not. (The remaining profits are taxable to the shareholder at his or her individual income tax rate--this is referred to as pass-through taxation--as are the profits from a sole proprietorship). Therefore an S corp has the potential to provide tax savings that may be significant depending on the situation.

Of course, there may be other costs that come into play with an S corp such as federal and/or state unemployment taxes that may need to be paid and associated costs for payroll administration. Other tax implications may include the realization of a capital gain in the event of an asset transfer between the entity and its shareholder that might not exist with another business structure such as an LLC. A consultation with a CPA is recommended to explore the possible tax implications and to determine whether forming an S corp would be beneficial for you.

About Personal Service Corporations
You mentioned the personal service corporation. A corporation (specifically, a C corporation) is classified as a personal service corporation if its primary work is in the performance of certain personal services and those services are primarily performed by owner-officers of the corporation.

The IRS defines these personal services to be services performed in the following fields: Consulting, accounting, actuarial science, architecture, engineering, health (including veterinary services), law and the performing arts.

Personal service corporations usually DO NOT save you money! In fact, quite the contrary.

A C corporation is a separately taxed entity. The net taxable income of a corporation is taxed at corporate income tax rates which start at 15% and increase depending on a graduated scale depending on the amount of taxable income . . . unless the corporation is classified as a personal service corporation: Personal service corporations are taxed at a flat rate of 35%!

Therefore, a business owner who plans to provide services in the fields referenced above may choose to form an S corp, because S corps as pass-through entities avoid this tax classification.

Michelle
Incorporation Specialist

*In 2006, the first $94,200 of total net income is subject to the social security portion of self-employment tax. All of the net income is subject to the Medicare portion.

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