S Corps to reduce self-employment income

Using S corporations to reduce self-employment income

• Income that you generate conducting your business as a sole proprietorship (or through a wholly-owned limited liability company (LLC)) is subject to both income tax and self-employment tax. The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for social security up to the social security maximum ($106,800 for 2010) and a 2.9% rate for Medicare, without any maximum.
• Similarly, if you conduct your business as a partnership in which you are a general partner, in addition to income tax you would be subject to the self-employment tax on your distributive share of the partnership's income. However, if you conduct your business as an S corporation you will be subject to income tax, but not self-employment tax, on your share of the S corporation's income.

An S corporation is not subject to tax at the corporate level. Instead, the corporation's items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you can avoid self-employment income tax.

There is a problem, however, in that IRS requires that the S corporation pay you reasonable compensation for your services to the S corporation. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax.

If the S corporation does not pay you reasonable compensation for your services, IRS may treat a portion of the S corporation's distributions to you as wages and will impose social security taxes on the deemed wages.

How much compensation is “reasonable”? There's no simple formula. IRS tries to determine the amount that similar companies would pay for comparable services under like circumstances. Factors that are taken into account include:

• the employee's duties;
• the amount of time required to perform those duties;
• the employee's ability and accomplishments;
• the complexities of the business;
• the gross and net income of the business;
• the employee's compensation history; and
• the corporation's salary policy for all its employees.

There are a number of concrete steps you can take to make it more likely that the compensation you earn will be considered “reasonable,” and therefore deductible by your corporation. For example, you can:

• Use the minutes of the corporation's board of directors to contemporaneously document the reasons for the amount of compensation paid. For example, if compensation is being increased in the current year to make up for earlier years in which it was too low, be sure that the minutes reflect this. (Ideally, the minutes for the earlier years should reflect that the compensation paid in those years was at a reduced rate.)
• Avoid paying compensation in direct proportion to the stock owned by the corporation's shareholders. This looks too much like a disguised dividend, and will probably be treated as such by IRS. If you are trying to avoid Social Security and Medicare on S Corporation earnings the IRS will treat it as wages subject to the above taxes
• Keep compensation in line with what similar businesses are paying their executives (and keep whatever evidence you can get of what others are paying—e.g., salary offers to your executives from comparable companies—to support what you pay if you are later questioned).
• If the business is profitable, be sure to pay at least some dividends or S Corporation draws. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.