S Corps: Salaries or distributions?

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 If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax.  If you put the business into an S Corporation, none of the income will be subject to self-employment tax.  Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.There is a catch.  In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends.  With S Corporations, the Service may take the position that corporate distributions are actually disguised salary.  That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff.  When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea.  I mean, nothing ventured, nothing gained.  What is nasty is the $6,000 or so in penalties.

If your business is reasonably profitable, don’t even think about taking less than whatever the unemployment wage base is in your state is.  That varies substantially by state ranging from $7,000 in Arizona to $39,800 in Washington.  By going below that limit you end up with another group of enforcers being interested in you.  My limited experience with them is that they are very stubborn and since there are not many dollars at stake the temptation will be to just pay it. There is then the potential that they will rat you out to the IRS.

 

If your business is quite profitable, be a sport and take something over the FICA maximum.  The savings can still be quite substantial.  Newt Ginrgrich took about $250,000 in salary with profits over $2,500,000 in his S corporation.  That got him some bad press, of course, but you are probably not going to be running for President.  It is worth noting that the President, himself, did not play this particular game and paid SE tax on all the net income from his book royalties.If you convert a proprietorship to an S Corporation, there are some costs to weigh. If you are going to take salary below the FICA max, there may be an effect on future social security benefits.  Actually quantifying that is challenging, but you can give it a shot with some of the calculator programs.  I have never gone through that exercise and my experience is that most business owners are dismissive of it.  So you can take that factor as a “just saying” if you want.

Operating as an S Corporation will require another tax return to be filed, which might cost something.  In principle, your individual return should be somewhat easier, since a Schedule C is no longer required.  You may need to “remind” your tax preparer of that in order to realize that saving on the individual return that might offset some of the cost of the S Corporation return.  If you are a brown paper bag type of client with a masochistic CPA, the realization on doing your return might be so lousy that even without your Schedule C, standard charges might come out higher than what you paid in the previous year.  On the other hand if you are a mensch with a CPA who “knows how to bill” your fee will never go down from one year to the next if you don’t ask.

Although there is a good chance that the potential for your individual return being audited will go down, the S Corporation return will be another return that potentially could be audited.  I don’t know how that balances out and I suspect that nobody knows, although you will find plenty of people who will tell you they know.

If your business involves significant debt and has irregular income, there are a lot of tax traps in operating as an S Corporation.  It gets really complicated if you have multiple businesses and real estate ownership is somehow involved.  If you are the type of person inclined to pay the bills out of whatever account happens to have sufficient cash and let your accountant sort it out with journal entries, you may be setting yourself up for an income tax nightmare in your quest to save a few thousand dollars in SE tax.  I have known partners in professional practices who contributed their partnership interests into S Corporations and encouraged me to do the same.  I never regretted not doing it and they came to regret having done it, except the one who died.  I’m pretty sure his executor really regretted it.