I watched the CNBC television show, “Blue Collar Millionaires” over the summer.

A good show, episodes (rightly) hammer home the point that America provides tons of great small business opportunities for entrepreneurs who don’t mind working with tools or coming home with a little dirt on their clothing.

The show has gotten me thinking, though, about something else. Which is this: How profitable a blue collar business do you need in order to justify an S corporation?

Fortunately, if you’ve got a blue collar business, or really any small business, you can answer this question by looking (briefly) at the cost of an S corporation and then at the typical benefits an S corporation delivers.

I’m going to try and help you do this here by talking about the costs to set up a small “blue collar” S corporation. And by also looking at the impact of Subchapter S status on three example businesses. One business making $40,000 a year, another business making $80,000 a year, and a third making $120,000 a year.

Tip: Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator

Costs to Set-up Blue Collar S Corporation

Okay, just to get this awkward bit out there first, probably you will pay at least a few hundred dollars to set up an S corporation and then pay one to two thousand dollars a year to operate the S corporation.

States, for example, charge you modest one-time fees for forming an LLC or corporation (often $100 to $200). But the good news is, you can usually do the paperwork yourself using free online forms or working with online applications supplied by your state’s Secretary of State. (You can also get additional help by looking at the short, step-by-step instructions available at this blog—just click on the LLC Formation Kits link at the top of this webpage and select your state from the list that appears.)

Another cost to consider: Operating an S corporation does bump your annual accounting costs in a couple of areas. You will pay a few hundred dollars in additional payroll taxes for unemployment insurance to either your state or to the IRS.  You’ll also probably  need to pay a CPA or enrolled agent a thousand dollars or so to prepare the more complicated, new, corporate tax return you need.

Finally, one last cost to remember: You may in some states pay substantial annual fees or franchise taxes simply because you have an S corporation. (California is the worst, I think, and charges you nearly a $1,000 a year no matter what your business earns in the way of profits… so read this blog post if you’re in California.)

In summary, then, an S corporation costs a few hundred bucks at least to set up.  And it’s easy to find yourself paying maybe $1,500 in extra annual accounting costs.

The question, then, is when does a blue collar business save money by operating as an S corporation?

The $40,000-in-Profits Small Business

Let’s look at a really common case first—the case where a small business makes a profit to the owner of $40,000.

Note that this might be a business with $50,000 in revenues and $10,000 in expenses, because $50,000 minus $10,000 equals $40,000.

Or this might be a $400,000 business with $360,000 in expenses, because $400,000 minus $360,000 equals $40,000.

Can an S corporation work in a situation like this? Well, it’s tricky. And here’s why.

If a business operates as a sole proprietorship and makes $40,000 in owner profits, the proprietor pays a 15.3% self-employment tax on the $40,000.

Note: The actual self-employment tax formula is a little bit complicated because for purposes of the formula, you adjust the profit number for half of the self-employment taxes. But you can ignore this complexity for purposes of our discussion.

If this business operates as an S corporation, the business owner will need to pay the 15.3% employment tax only on the portion of the profit that he or she calls “wages.” The business owner, therefore, avoids paying the 15.3% tax on the extra leftover amount that’s not called “wages.”

Avoiding the 15.3% tax on a chunk of the business profit is the tax benefit you get when you operate as an S corporation

But here’s the problem. The business will need to pay its owner a reasonable wage. That’s the rule. And probably in a situation where the profits equal $40,000, most and possibly even all of the profits will need to be called “wages.”

So in the $40,000-in-profits scenario, the business owner may pay a few hundred dollars to set up the S corporation. He or she may pay, gosh, $1,500 a year in extra taxes and CPA fees to operate as an S corporation.

And then because the owner needs to take all of the $40,000 of profits as wages, he or she will still pay that 15.3% tax on all of the business profits.

In this scenario, probably, the S corporation doesn’t work to save the entrepreneur payroll taxes. Sorry.

The $80,000-in-Profits Small Business

Okay, what about a situation where the business generates $80,000 in profits for the owner?

Well, oddly enough, even though this situation doesn’t seem that radically different from the $40,000-in-profits business—this may simply be the same business five years farther down the road—this business probably can save money.

In a situation where a small business earns $80,000 in profits and operates as a sole proprietorship, the owner pays that 15.3% self-employment tax on roughly $80,000. When you work out the actual tax bill, due to the formula complexities mentioned earlier, the actual self-employment tax bill will be a little less than $12,000.

But here’s the deal: The typical S corporation pays its shareholder-employee $40,000 a year in wages. And if $40,000 is the reasonable “wages” number, the business owner will only pay the 15.3% tax on this $40,000 chunk of the profits. That’ll equal roughly $6,000.

In this case, the business owner saves nearly $6,000 a year in payroll taxes.

The bottom-line? Even if the corporation costs a few hundred dollars to set up and costs (say) $1,500 a year to operate, probably the S corporation option begins to look attractive.

Note, too, that in a situation where a fifty-fifty split between “wages” and “non-wages” doesn’t work because $40,000 in wages isn’t reasonable, a clever accounting can still produce nearly $6,000 of savings.

I’m going to talk more about this in the next section, but mechanically, amounts a shareholder-employee receives for health insurance, health savings accounts, and pension plan contributions such as a SEP-IRA either count as wages but aren’t subject to the 15.3% tax or they reduce the “non-wages” amount the IRS gets cranky about.

The $120,000-in-Profits Small Business

With a $120,000-in-profits small business, the tax savings associated with an S corporation often become irresistible.

If such a small business pays its owner $40,000 in “wages,” that means he or she saves paying the 15.3% tax on roughly $80,000 of additional business profits and therefore enjoys nearly $12,000 in annual payroll tax savings.

Clearly, spending a few hundred bucks and maybe $1,500 a year to annually save nearly $12,000 in payroll taxes is a great deal.

In fact, quite honestly, this scenario produces such giant savings, it’s probably a little suspect.  Or worse.

Remember the rule of S corporation compensation mentioned earlier: Your S corporation needs to pay you reasonable wages.

However, even a $40,000-ish in base wages scenario might in many situations work.

You want to confer with your CPA about this, but here’s an example of how a $120,000-in-profits small, blue collar business might be able to save nearly $12,000 annually in payroll taxes.

Suppose the base salary you pay yourself equals $42,000. Further, suppose that your corporation pays $10,000 a year for your family’s health insurance and also makes a roughly $8,000 health savings account contribution. In this case, only the $42,000 base salary gets subjected to the 15.3% payroll tax… yet the health insurance and health savings account amounts count as wages, too.

If you set up a pension plan that allows for a 25%-of-wages employer contribution, that means you essentially add another $15,000 to your employee compensation (25% of the $42,000 in base wages plus $$10,000 of health insurance plus $8,000 in health savings account)

With these numbers, you might enjoy roughly $75,000 in wages and tax-free fringe benefits, which may be enough to qualify as “reasonable.” Yet only $42,000 will be subject to the 15.3% payroll tax.

And then note that you still have another $45,000 in leftover profits in this case on which you have avoided the 15.3% payroll tax. This is the chunk of business profits the IRS may want to talk to you about… but it very possibly might not cause the IRS any problems. You may, for example, leave some of this money in the business to fund growth—and the IRS won’t care about not collecting the 15.3% tax on that reinvested profit. And then you should be able to draw some money out of the business as “non-wages” just because the shareholders should be entitled to a return on their investment.

Closing Caveats and Comments

Can I share some quick, random caveats and comments in closing? Good.

First, you can use either an LLC or a corporation as the “base” of an S corporation. I commonly recommend people use an LLC because limited liability companies often are easier to set up and operate. (Here’s a page where I talk more about this choice.)

Second, you will need to do a couple of “paperwork” tasks after you get your LLC or corporation set up: First, get your new LLC or corporation an employer identification number (something I describe here). And, second, formally elect to Subchapter S status (something I describe here).

Third, I’ve got another blog post here that describes how to avoid state-level payroll taxes in a handful of states. You probably want to peek at that.

Fourth, if you’re a Washington state S corporation, check out this checklist for a first-year Washington state S corporation.

Fifth and finally, you really, really, really do need to be careful about how you set your compensation. Goof that up and you’ll (in a worst case scenario) find yourself in hot water with the Internal Revenue Service and possibly with your state’s unemployment insurance folks, too. (You might want to consider our downloadable ebook on setting S corporation salaries available here.)

Are You a Small Business Owner Looking to Reduce Taxes?

Small business owners often don’t do a good job with maximizing their legitimate tax deductions.

For example, business owners usually don’t go to the effort of structuring their operations to protect legitimate deductions, to create new deductions and to recycle (or double-deduct) the deductions which can be used more than once to save taxes.

Which is really too bad. Getting disciplined and smart about small business tax deductions can save businesses and their owners a bundle in taxes.

If you’re thinking maybe you can do a better job with your tax deductions, consider downloading our $40 e-book, Small Businesses Tax Deduction Secrets. This short e-book provides detailed instructions about how business owners can annually save thousands or even tens of thousands of dollars in income and related taxes simply by more effectively using legitimate small business tax deductions.

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Not every one-person corporation pays or even can pay an annual salary of $40,000 to the shareholder-employee. But a salary of $40,000, it turns out, is roughly the average salary paid by a single-shareholder S corporation to its shareholder-employee.

Accordingly, this post describes a quick-and-dirty approach to simply, easily and correctly prepare payroll for a one-person corporation when the shareholder-employee makes $40,000.

Step 1: Set a Reasonable Salary

Step 1 is setting a reasonable salary. And so let me issue a caution here.

While I’ve arbitrarily set the salary to $40,000, you absolutely must verify the salary you pick for a one-person corporation is reasonable.

Tip: You may want to review the average S corporation salaries data we provide at our “S Corporations Explained” website.

By the way, you may very well conclude that a $40,000 annual salary is appropriate. And if that’s the case, you can use the numbers and examples provided here as your own.

Step 2: Calculate the Payroll Amounts and Taxes

Once you know the correct salary to pay yourself as a shareholder-employee, you calculate the payroll amounts and taxes.

For purposes of the method described here, you think in terms of quarterly payroll amounts and taxes.

Rather than a $40,000 annual salary, for example, you think in terms of a $10,000 a quarter salary.

Calculating the employer’s payroll tax burden

Your corporation pays a 7.65% Social Security and Medicare payroll tax. If your S corporation pays you payroll of $10,000 a quarter, that amount equals $765 obviously.

Calculating the employee’s payroll and income taxes

You (the employee) also need to pay a 7.65% payroll tax as an employee. If your corporation pays you payroll of $10,000, that’s another $765.

You also need to pay federal income tax. Rather arbitrarily, I’m going to set the federal income tax to $750 a quarter, so over the year, you’ll have paid $3,000. But in many situations where $40,000 is the appropriate wages amount, this amount of federal income taxes will pay the federal income taxes.

Calculating the net wages amount

With a $10,000 a quarter salary and the preceding payroll taxes, you need to pay yourself $8485 each quarter in net wages.

Note: The corporation will hopefully disburse more than $8485 a quarter to you. But the first $8485 will count as wages. The checks you write after reaching the $8485 threshold will represent shareholder distributions. For example, if you also write a $1000 or $2000 check each month payable to the shareholder and this amount is not payroll, you categorize that disbursement as a distribution.

Step 3: Preparing the Federal Quarterly Payroll Tax Return

With a $10,000 quarterly payroll, you don’t need to make next-day or next-week deposits of payroll taxes you’ve withheld from employee payroll checks.

Instead, you can deposit the taxes when you file the quarterly 941 payroll tax return, which you can download from the Internal Revenue Service’s web site (click here to grab form).

I’ve included an image below that shows you what a completed 941 looks like when you’re paying a shareholder-employee $10,000 a quarter and withholding $750 a quarter in federal income taxes. You of course enter the employer identification number, name and address information with your actual information.

You also need to check the right “Report For This Quarter” box in the upper right corner of page 1 (check January, February, March for the first quarter, for example). And you need to sign the return. Note also that your state and whether or not you send in a payment determines which address to send the form to. But all the other information shown on the 941 in boxes 1 through 15 and on the 941-V would match what I’ve plugged in here.

After you complete and sign the 941 form, you write your check for $2,280 and then mail the 941 return, including the 941-V coupon, and your check to the appropriate address.

Tip: If you want more information, you can get that information from IRS instructions. Click here to download those instructions.

Step 4: Record the Payroll Transactions into Your Accounting System

You’ll also need to record your payroll transactions into your accounting system. So let me just talk about that quickly.

Recording the employee checks

You need to pay your shareholder-employee (this is you of course) $8435 in wages during the quarter. And you can do this in any way you want. You can write a check on the first or the last day of quarter for $8,485. Or you can write several checks over the course of the quarter that total $8,485.

All of these checks should be categorized as wages expense.

As noted earlier, if you make additional disbursements to the shareholder (and hopefully you will be doing this), you categorize these amounts not as wages but as shareholder distributions.

Recording the $2,280 check to the IRS

Recording the $2,280 check to the IRS works a little differently. This check actually represents two expense categories. A $765 chunk of the check represents the employer Social Security and Medicare taxes triggered by the $10,000 in total payroll. The $1,515 remainder represents the employee’s taxes that the law says the employer needs to withhold and then remit on the employee’s behalf.

This $765-$1,515 breakdown means is that you need to split the $2,280 check which gets included with the 941 form into two categories: $765 categorized as payroll taxes, and $1,515 categorized as wages expense.

Note: After you’ve categorized the $8,485 check to the employee as wages expense and also $1,515 of the check that goes with the 941 return as wages expense, your total wages expense for the quarter equals $10,000 ($8,485 + $1,515 = $10,000).

Step 5: Preparing State Payroll Tax Returns

Some states (like Washington State where I live) don’t require additional state quarterly payroll returns for shareholder-employees in one-person corporations. And if you operate in a state like this, you may only need to prepare and file the federal 941 tax returns over the course of a year.

Tip: If you are in Washington state, though, see this post so you don’t get caught in a dumb trap set by our state legislative.

But many other states you to prepare quarterly state payroll tax returns. As a generalization, these state quarterly payroll tax returns (if required) are pretty simple to deal with.

Some of the quarterly state returns amount to simple worksheets that, for example, levy a 3% tax on wages for state unemployment insurance premiums. Or simple worksheets that, as another example, charge a $.10 per hour tax on worker hours for workers compensation insurance. Other quarterly state payroll tax returns resemble the federal 941 return.

But you shouldn’t need to worry too much about all of this. Probably, your state employment agency will send you automatically information on these state returns. In this case, you need to make a couple of phone calls so you get any quarterly forms you need.

Step 6: Dealing with Any Tax Shortfalls

If paying $3,000 in income taxes won’t be enough using the method described above is not enough, you should augment the federal income taxes paid through your payroll by making quarterly estimated tax payments using the 1040ES form. For example, suppose that you know you’ll really owe $6,000 in income taxes. If through payroll withholding you’ll only pay $3,000, you’ll want to pay another $3,000 annually, or $750 a quarter, in quarterly estimated tax payments.

You can determine precisely how much federal income tax you should pay over the year by downloading the 1040-ES estimated tax payments form from the www.irs.gov website and completing the tax liability worksheet included with that form.

Note: To make regular state estimated tax payments, use your state’s equivalent to the federal 1040-ES form. For example, if you’re in California and need to pay, say, $500 a quarter in California state income taxes, you can use California’s 540-ES quarterly tax payment form.

Step 7: Preparing the Year-end Payroll Tax Returns

Even after you prepare the employee paychecks, file the quarterly payroll tax returns, and make the payroll tax deposits, you still have a small handful of additional, year-end payroll returns that need to be completed.

For example, at the end of the year, you’ll need to prepare and file a 940 Federal Unemployment Tax return. That return will assess a $420 tax if you’re a one-employee corporation in a state that doesn’t levy state unemployment tax on shareholder-employees. And that return will probably assess a $42 tax if you’re a one-employee corporation in a state that does level state unemployment tax on shareholder-employees.

Furthermore, you will need to prepare a year-end W-2 and W-3 for your employee and submit to the Social Security Administration and, possibly, to a state agency.

And it’s possible that you may have one or two additional, state related year-end tax returns to file as well.

Here’s my suggestion as to how you handle these year-end payroll tax returns: Have the person who prepares your corporation tax return prepare these year-end payroll tax returns. In other words, have the CPA who’s already doing the 1120S or 1120 corporate return do your 940 FUTA return, your W-2 and W-3 and any other state returns. He or she can easily and economically prepare these returns with the corporation return. To outsource the year-end payroll returns, get in to see your accountant early in January. Most payroll returns need to be filed by the end of January.

Some Final Comments

You have a bit of flexibility in applying the quick-and-dirty method described here. For example, if $40,000 a year in salary is too high, you can simply halve the wage and tax numbers given in the preceding paragraphs. This would of course mean you pay $20,000 in payroll over the year.

Furthermore, if you don’t or can’t do a full year of payroll, you could do, say, three quarters of $10,000-a-quarter payroll over the year. (This might make sense if your total payroll for the year should be $30,000.)

If you need to pay a reasonable annual salary of more than $40,000, you can use the basic approach described here but pay not $10,000 a quarter but rather $16,000 a quarter. (The numbers you use to do $16,000 a quarter of payroll differ as discussed in our “Five Minute Payroll” e-book which is described below.) And a $16,0000 quarterly payroll gets your shareholder-employee compensation to $64,000 a year–which should work for many S corporations.

Here’s why all this works: The quick-and-dirty payroll method described here works because of an intentional loophole in the payroll tax laws. The loophole, in a nutshell, says you can make your payroll tax deposit with your 941 tax return as long as the amount you owe is less than $2,500. If you need, therefore, to pay yourself $20,000-a-quarter, you’ll owe more than $2,500 by the end of the quarter. This breaks the loophole-related rule that opens the door to the quick-and-dirty method.

Five Minute Payroll System: Get More Details in our $20 Monograph

The Quick and Dirty Payroll Method described on this page provides a fast and easy way to handle payroll in simple situations where your annual shareholder-employee compensation is less than or equal to $40,000.

However, people have regularly asked us to explain how to use the system with a larger salary amount and also to provide a cleaner, fuller monograph with forms that the small business corporation can simply add their name, address and EIN to. So that’s what we’ve finally done with our $20 monograph, Five Minute Payroll.

The Five Minute Payroll monograph explains how to do simple cookie-cutter payroll for most one-employee S Corporations using base salary amounts of $10,000 a quarter or $16,000 a quarter. (These amounts, especially if combined with a pension or health benefits, will work for almost everyone.) The e-book includes sample IRS forms you can copy to get your quarter end or year end payroll done in a few minutes, including 941s, W-2/W-3 and 940. Furthermore, the e-book provides some common-sensed tips you can use to set a reasonable salary for your S corporation and to minimize your state payroll taxes burden, too.

Interesting in buying and then immediately downloading this monograph? Click this button:

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As with all of our monographs, our products come with a money back guarantee. If you don’t think what we deliver is worth it, just let us know and we’ll refund your purchase price. We make this promise to you confident that paying $20 once to save hundreds of dollar a year (or more!) on an outside payroll service will be a great investment. Note, too, that the biggest saving to you probably won’t be the money but the time.

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