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You can take advantage of a rare tax benefit as owner of an S Corporation to reduce self-employment tax.  Just don't overdo it!

Bruce Swabb, CPA

A few years back, I was working with a client to determine whether they should set up their new business as a limited liability company or a Subchapter S corporation.  I had worked with both entity types for many years, but the lightbulb finally lit up for me that the PRIMARY reason for selecting an S corporation was to reduce self-employment taxes on owner income.

What a great planning opportunity!  But, as the title to this post hints, you can take the tax break too far and end up in trouble with the IRS.

A little bit of background

Both an LLC and an S Corp are pass-through entities.  Meaning the company itself does not pay income tax, but passes all earnings through to the owners (members or shareholders) and the income is taxed only once for income tax purposes.  This is reported to you each year on a form called a Schedule K-1.

A big difference between the two is that pass through income from an LLC is subject to self-employment tax.  The first $118,000 of the income from your LLC is subject to self- employment tax at a rate of 15.3%! Anything above $118,000 continues to be subject to Medicare tax.

An S Corp allows you to treat yourself as an employee and earn a salary.  This salary is then subject to payroll taxes just as any other employee of the company.  You still effectively pay the 15.3% rate – because you are paying both, the employee and employer share of the payroll taxes. 

The cool part though, is you set your salary at a reasonable amount, with no direct relationship to the net earnings of the business. You pay payroll taxes only on that salary, not the entire earnings of the business.

A quick example - the business throws off net earnings before your compensation of $100,000.  Under the LLC entity, this income would result in self-employment taxes of $15,300.  Yikes. 

Now, let’s say you pay yourself a salary of $50,000.  You will pay payroll taxes on your salary, and you can also have income taxes withheld from each paycheck.  The Social Security and Medicare taxes from your salary will total $7,650 for the year.

The salary you pay yourself is a tax deductible expense at the S Corp level and it reduces the net earnings reported to you on Sch. K-1.  In our example, you will pick up the salary as wages reported on form W-2 and the remaining $50,000 pass through income as reported on the Sch. K-1.  So, you still take the full $100,000 into income for income tax purposes.  Remember - we are talking about self-employment tax, which is a payroll tax. This $50,000 of Sch. K-1 pass-through S Corp income is NOT subject to self-employment tax.  In this example, the S Corp results in payroll tax savings of $7,650 versus the LLC.  Not chump change.

I have no idea how or why this different treatment came about.  It may have simply been an oversight.  I know that Congress is well aware of the benefit, and has declined to repeal it.

Now for the part about the Hogs…

As mentioned above, Congress is aware of the benefit.  And the IRS is aware of the benefit – and the IRS is not happy about it.  When the hit to the Treasury came to light, the IRS tried earnestly to get the law changed and to strong arm business owners into paying the full self-employment tax on pass-through earnings.  The courts have beaten back the IRS and protected taxpayers when reasonable compensation has been reported on tax returns.

The IRS doesn’t go down without a fight…

After failing to get the law changed, the IRS began specifically screening the Officers Compensation line of S corporation tax returns, form 1120S, to select audit candidates.  Guess what? If you have been a hog and reported either zero compensation, or a ridiculously small amount of compensation, you are a strong candidate for audit.

The wise approach is to pay yourself a reasonable annual salary.  Enjoy the benefit, without overindulging.  I counsel my clients to think about a monthly amount that is more than enough to cover their monthly living expenses plus a chunk for entertainment.  It will be hard for the IRS to get too rough with you under this approach, but of course, they can propose any adjustment they desire.

If you find yourself in this situation, have a discussion with your tax advisor.  The potential audit assessments can be quite large – the part where the hog gets slaughtered.  If the IRS decides to go after you on this issue, they are going to propose that all of your pass-through earnings should be treated as compensation. 

If instead, you take a reasonable and consistent approach, you can enjoy a very rare tax benefit without getting smoked and slathered with BBQ sauce by the tax man.