There’s an old Morgan Stanley slogan that says “You must pay taxes. But there’s no law that says you’ve gotta leave a tip.” That’s a great attitude to keep in mind as we work through all of this material.
Self Employment Taxes
Let’s start with the problem we’re looking to solve, and that problem is too much self-employment tax. Most businesses start out taxed as sole proprietorships. Even if the owner establishes an LLC, they usually elect the default tax treatment, which is a disregarded entity. This means the business is taxed as a sole proprietorship. The owner will report the business net income on Schedule C. Then the business net income is subject to regular income tax.
The business net income is also subject to self-employment tax. For 2017, this is 15.3% on the first $128,400, plus 2.9% on everything else, plus a potential 0.9% on amounts over $200,000 for individual filers or $250,000 for joint filers.
Lots of accountants dismiss the self-employment tax, especially once you exceed the $127,200 Social Security wage base. But it adds up fast. In our example, we have an owner netting $80,000, and paying $11,304 in SE tax before they can even look at their regular income tax.
While we’re at it, it’s worth mentioning that the rules work essentially the same if you’re a partner in a partnership. That is to say, you pay regular income tax on your partnership income, and self-employment tax on it as well.
How Self Employment Taxes Benefit from S-Corps
Establishing an S corporation solves that problem by dividing your net income into two halves, one of which is NOT subject to employment tax. Here’s how it works. The corporation will pay you a salary for the service you perform as an employee. You’ll get a W2 for that amount, just like any other employee. The rest of the income will pass through to your personal tax return as a dividend.
You’ll pay regular income tax on both halves, the salary and the dividend, just like you did with your sole proprietorship income. You’ll pay employment tax, in the form of FICA withholding, on the amount you take as salary. It’s the same 15.3% up to that $128,400 (2018) Social Security wage base, plus 2.9% on anything above that, plus 0.9% of wages above $200,000 for individual taxpayers and $250,000 for joint filers.
But, and here’s where the magic happens, you’ll avoid employment tax entirely on the amount that passes through to you as a dividend!
Employment Tax Comparison: Proprietorship vs. S-Corp
Let’s take a quick look at some numbers to see what sort of savings we can create. A minute ago, we looked at a business owner earning $80,000 as a sole proprietor, paying $11,304 in SE tax. If we establish an S corp (or cause an existing LLC taxed as a sole prop to make an S election) and pay a $40,000 salary, we’ll save $5,184 in employment tax. This is especially valuable because we’re simply eliminating a tax. We’re not asking you to put $5,184 into a retirement plan, and then deduct it, or take $5,184 and buy new equipment, and then deduct it. We’re simply avoiding that $5,184 in self-employment tax
“Reasonable” Salary & Audit Odds for an S-Corp
Now let’s look at the fine print, because I already know what you’re thinking. Why not pay zero salary, or a ridiculously low amount like a thousand dollars a year? Well, the rules require you to pay yourself a “reasonable” salary for the work you do as an employee for the corporation. And that’s not always easy to determine! The IRS and Tax Court look at several factors when there’s a dispute over reasonable compensation.
The nature of the business (professional services firms are more dependent on the owners’ personal effort)
The employee’s qualifications, responsibilities, and time devoted to the business
Compensation compared with non-shareholder employees or previous years
Amounts comparable businesses pay for comparable services
Compensation as a percentage of corporate sales, corporate profit, and total distributions
The IRS Statistics of Income division publishes spreadsheets reporting all sorts of mind-numbing statistics. This includes the average amount of salary that S corporation owners, in aggregate, pay in the form of officer compensation versus the amount they take as income dividends. For 2013, that percentage was 32.13%. Now, I am ABSOLUTELY NOT suggesting you take that percentage as any sort of guideline or safe harbor. However, I do want you to see that using the S corp to minimize employment tax is a well-established, mainstream planning strategy.
If you work with me, I help my clients determine an IRS approved “reasonable salary” and provide a written report that details how we determined your salary. The IRS loves these reports because it is, in essence, a smoking gun if they question the reasonableness of your salary. It’s very easy to do - we discuss the work you perform, I send you an online based interview form, I review and analyze your interview form, and a report is prepared for your records.
Organizing your business to be taxed as an S corp can significantly lower your risk of getting audited. You’ll see that for 2014, the Schedule C audit percentages varied from 1% for returns grossing up to $25,000 to 2.4% for returns grossing $100K-200K. S corp odds, in contrast, were just four-tenths of one percent. That’s less than 20% of the highest schedule C odds.
S-Corporation Set Up Requirements
Okay, let’s cover some nuts and bolts. There are two ways to skin this particular cat – an actual corporation or a limited liability company. Either way, you’ve got to register the entity with the state, then get an employer ID number, then file the actual election, which you’ll make on Form 2553.
The regular deadline for filing an S election is 75 days after the start of the year for which you want to make the election effective. Ordinarily that means March 15.
However, if you miss that deadline – or you get to December and realize you should have made the election long ago – it may be possible to make what’s called an S election. In fact, it’s common enough that the IRS lets you attach the Form 2553 to make that election, to the first S corp return you file. Rev. Proc. 2013-30 says you can go back as far as three years and 15 days. Now, if you’ve already filed three years of proprietorship or partnership returns, they’ll probably shoot you down. But if you have a a couple of unfiled returns, this might be a way to take those lemons and turn them into lemonade.
The IRS isn’t shy about shooting down late elections. But just because the IRS says “no” doesn’t mean all is lost. Plenty of business owners have appealed those turndowns and wound up winning.
Ongoing Maintenance for Your S-corp
Quarterly - Once your S-corp is all official, you’ll have some ongoing paperwork requirements. You’ll need to start filing payroll returns for yourself. You’ll also need to manage state unemployment and workers’ comp premiums, and adjust your own estimated taxes to reflect amounts you’ll be withholding from your paycheck.
Annually - At the end of the year, you’ll need to prepare W2s and Form W-3, along with a federal unemployment return and various state and local returns. You’ll also need to follow some state formalities for your corporation or LLC. These may not seem important – but if you ever wind up getting audited, or sued, you’ll be glad you can show you dotted your I’s and crossed your T’s!
Frequently Asked Questions
QUESTION 1: When should someone use a LLC (disregarded entity) versus an S-corp?
There are a few things to consider:
The amount of profit you have. Generally, if your profit is less than $70,000, the S-corp will usually not be beneficial to you.
You’re not willing to comply with the business requirements (separate bookkeeping, payroll, etc)
What state/city are you in? New York City has an additional almost 9% corporate tax on profit for S-corps, essentially doubling the tax
Section 199A deduction - you have to examine whether reporting your profit on the Sch C will provide a large enough 199A deduction to offset the self employment tax savings.
QUESTION 2: Are there any particular industries S-corps don’t work well in?
Here’s a situation that sometimes comes up with licensed contractors like real estate and insurance agents, and a potential workaround.
Let’s say you’re a real estate agent. You have a contract with your broker, in your own name because you hold your agent’s license personally. At the end of the year, the broker sends you a 1099, with your personal social security number on it to report your income. But now you want to set up an S corp.
What do you do? It used to be that you could just “nominee” the income to your corporation. That would involve reporting the 1099 amount on your Schedule C, deducting that same amount to zero out the income on your personal return, then report it on the corporate return. But in December 2016, the Tax Court issued an opinion in the Fleisher case, TC Memo 2016-238, that said you can’t just do that. You can’t move the income to the S corp unless the corporation “controls the earning of the income.”
The easiest solution would be to execute a new contract with your broker that pays the income directly to the corporation. Problem solved. BUT, that’s not always possible.
State licensing laws might require licensed contractors to receive commissions individually. Or the entity paying the commission might have its own rules. In that case, consider setting up a contract between you and your S corporation where you outsource part of your duties. For example, if you’re a realtor, you might hire your corporation to do your marketing, prospecting, and selling activity, in exchange for 90% or 95% of your gross commission income.
And be sure to dot your I’s and cross your T’s! For example, if you get audited, you’ll want to be able to show the IRS that money really did flow between your individual and your corporate bank returns. This is a brand-new problem to solve, so we can’t guarantee it will work. But it will give you the best shot we know of at getting you the benefit of S corporation status.
Want to Learn More About S-Corporations and if Its Right For You?
If you've made it this far, congratulations! If you still want to learn more I invite you to take advantage of my free tax analysis. I’ll sit down, walk through your tax return, and see where you might be able to do better. I’ll find the mistakes and missed opportunities that can cost you thousands in taxes you don’t need to pay. Then I’ll prescribe some solutions to help rescue those wasted dollars. Of course, we’ll pay particular attention to your business choice of entity. But we won’t confine ourselves solely to that sort of structuring if we find more places to save.