McVay Business Services - Accounting & Tax Services Pensacola, FL
How An S Corporation Can Reduce FICA Self-Employment Taxes
EXECUTIVE SUMMARY: One of the fundamental differences between corporations and partnership business entities is that the former faces “two tiers” of taxation – once at the corporation level, and again when profits are distributed as dividends to the shareholder – while the latter are only taxed once to their owners as “pass-through” entities. Of course, the reality is that there are a lot of factors that go into determining the right kind of business entity, beyond just the pass-through taxation treatment or not, though in practice it is often a material factor.
A hybrid mid-point between the two is an S corporation, which is recognized as a corporation for legal purposes – including for liability protection, and transferability of stock shares – but still taxed as a pass-through business, similar to a partnership.
However, in practice the pass-through tax treatment of an S corporation isn’t exactly identical to a partnership, because with a partnership all pass-through income is subject to self-employment FICA taxes (as high as 15.3%), while an S corporation only pays FICA taxes on salary compensation to its owners, and not the remaining profits paid out as nontaxable dividend distributions.
To prevent everyone from just converting partnerships into S corporations that all pay their owners $0 in salary – to completely avoid FICA taxes – the IRS still requires that S corporation owner-employees be paid “reasonable compensation” for the services they render to the business.
Nonetheless, the reality is that for highly profitable businesses, especially with multiple owners and/or multiple employees, there is clearly a portion of profits, over and above just reasonable salary compensation, that can be distributed as a dividend to the S corporation owners, saving FICA self-employment taxes in the process. For profitable businesses, the tax savings can be thousands or even a few tens of thousands of dollars in savings.
Ultimately, not all small businesses can take advantage of these rules. Some don’t meet the ownership requirements of an S corporation, and others are so small and dependent on their owners that realistically, “reasonable” compensation would be 100% of the business profits anyway. Nonetheless, there are many high-income partnerships (or LLCs taxed as such) that might benefit by switching to an S corporation (or making an election for the LLC to be taxed as an S corporation), specifically to split the business profits into FICA-taxable wages and FICA-exempt S corporation dividend distributions. At least, until or unless Congress shuts down this perceived “loophole” and reunifies the taxation of S corporation dividend distributions with the pass-through income of partnerships!
Pass-Through Tax Treatment Of S CorporationsThe traditional tax structure of a corporation entails two tiers of taxation. The business itself is a standalone entity that files a tax return and pays taxes on its income. And any of the corporation’s accumulated income that is subsequently distributed as a dividend to shareholders is taxed again (albeit at favorable “qualified dividend” tax rates).
However, the reality is that many small businesses don’t even have a separate entity; instead, they’re simply a sole proprietorship, where the business owner is taxed directly on his/her income. Similarly, many partnerships are really just a combination of individual sole proprietors, and applying this kind of two-tier corporate entity tax structure would be unduly complex, and not representative of the reality (which is simply two individuals coming together in a joint venture).
To accommodate this reality, the tax code recognizes that partnerships can be taxed as a “pass-through entity”, where even though there is legally a separate business entity, the income is not taxed to the partnership entity, and instead is simply passed through in relative shares to partners’ own individual tax returns. In the process, the two-tier double-taxation of corporate income is avoided.
The challenge for some businesses, though, is that they don’t want to structure the business as a partnership (or an LLC taxed as a partnership). In some cases, it’s because of the liability exposure that can still attach to at least the general partners of a partnership. In other cases it’s because there’s a desire to make the business more easily transferrable, especially in small pieces (e.g., for succession planning), and it’s much easier to transfer shares in a corporation than partial interests of a partnership or LLC.
Accordingly, the tax code allows for corporations to make an “S election”. By electing to be treated as an S corporation, the business is nominally a traditional corporation for legal purposes (with all the usual requirements to establish and maintain a corporation), but is taxed as a pass-through entity (similar to a partnership). This allows businesses to enjoy many of the transferability, limited liability, and other benefits of a corporation, but still get the pass-through treatment that avoids two tiers of taxation. (Under the “Check The Box” rules, an LLC can choose to be taxed as a partnership, or taxed as a corporation which subsequently can make an S election.)
However, to prevent potential abuse, the tax code limits the exact kinds of corporations that can make an S election, restricting both the number of shareholders (no more than 100), the types of shareholders (most types of trusts cannot own S corporations), and the classes of stock (S corps can only have one class of stock, albeit with voting and non-voting shares).
Notwithstanding the restrictions, though, for the typical small business owner who wants some of the structural benefits of a corporation, but the pass-through treatment similar to a partnership, the S corporation is an appealing midpoint.
S Corporation Dividends And FICA Self-Employment TaxesNotably, while S corporations are taxed as a pass-through entity similar to a partnership, the rules are not exactly the same.
When it comes to owners in particular, a key distinction is that with a partnership, any/all income allocable to an active partner in the business is automatically and fully treated as self-employment income, subject to FICA self-employment taxes (Social Security and Medicare employment taxes).
However, with an S corporation, the corporate roots – where payments to owners can occur either as salary compensation for employment, or as a dividend to ownership – is at least partially maintained.
Of course, it doesn’t make sense to pay a traditional “taxable” dividend from an S corporation, because the whole point is that it’s a pass-through entity, where the income of the S corporation is automatically and already taxed to the owners when the business earns it. As a result, taking money out of an S corporation is simply classified as a “distribution” – functionally it’s a dividend, but a nontaxable one because the taxes were already paid when the income was earned by the business to begin with. This ensures that an S corporation is only subject to a single tier of taxation.
Similarly, when an owner-employee of an S corporation receives a salary payment (i.e., for services rendered to the business), the payment is deductible to the business, and taxable to the owner-employee. The net result is substantively the same as an S corporation dividend – the income is only taxed once, to the owner-employee.
An important distinction, however, is that while both the pass-through income of an S corporation, and a salary payment from an S corporation, are ultimately taxable to the owner-employee, at ordinary income rates, their treatment is not identical. Because as “corporate” income, an S corporation’s pass-through income by default is not subject to employment taxes under Revenue Ruling 59-221, since it was not directly earned (even though it’s otherwise treated as ordinary income). By contrast, a salary payment is fully subject to FICA taxes.
In other words, S corporation owners actually have control over whether they will receive their business income as salary, or as a dividend distribution (of previously-taxed pass-through income), where only one is subject to FICA taxes but not the other!
Potential Self-Employment Tax Savings From S Corporations And Reasonable Compensation RequirementsThe fact that wages from an S corporation are subject to FICA taxes, but dividend distributions are not, can be a non-trivial impact. FICA taxes include a 12.4% Social Security tax up to the Social Security wage base (which will be $127,200 in 2017), plus another 2.9% of Medicare taxes (for an unlimited amount of income). In addition, there’s another 0.9% Medicare surtax on earned income above $200,000 for individuals (or $250,000 for married couples). In total, this leads to FICA tax rates of 15.3% initially, dropping to 2.9% beyond the Social Security wage base, and rising to 3.8% at higher levels of earned income.
Mike McVay - Sub S Corporation Tax Specialist - 850-725-5696
Mike McVay, Tax Accountant Blog
Certified QuickBooks ProAdvisor & Licensed Tax Accountant Pensacola, FL
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