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How to Eliminate up to 40 Percent of Your Social Security and Medicare Tax with an S Corporation
It’s a game. We [tax lawyers] teach the rich how to play it so they can stay rich—and the IRS keeps changing the rules so we can keep getting rich teaching them.
—John Grisham, lawyer and author, The Firm
I should note that this chapter won’t be long or complicated. In fact, it will probably be one of the shortest in the book. However, don’t let the short length fool you. The tax benefits here alone could make you a millionaire, if you invest the tax savings yearly.
Overview of Taxation for S Corporations
Unless you converted from a regular corporation to an S corporation,1 an S corporation is not subject to any tax.2
You would compute the corporation’s gross income and subtract any business deductions to arrive at the net taxable income. You would then file an individual return on your pro-rata share of the corporation’s net income or loss.3 The S corporation would not pay any tax on the income.
Example: Mary is a 50 percent shareholder in an S corporation. The corporation had gross sales of $500,000 and deductions of $400,000, for a net income of $100,000. Since Mary owns 50 percent of the stock, she would pay tax on one half of the $100,000, which is $50,000.
Author’s note: You pay tax on the net income of the corporation whether or not it’s distributed to you. Thus, if all the income were left in the corporation for growth, Mary would still pay tax on $50,000. This undistributed amount would raise her stock basis, however, as if she had paid $50,000 more for stock. If she receives any dividends, this would reduce the basis.
Some income items and deductions get separately stated on your individual return as if you’d earned them.4 Thus, such income items as tax-exempt income and capital gains and some deductions, such as charitable contributions, would be separately stated on your Form 1040 as if you’d earned these items.
The key to saving Social Security taxes is that with an S corporation you pay self-employment tax on wages, salaries, and bonuses but not on dividends.5 Your share of undistributed earnings is deemed dividends and not wages and is treated as any actual dividend distribution. Let me repeat this again because it is worth repeating: dividends and undistributed earnings are not subject to self-employment tax.
Thus, the key is to pay yourself as little in salary as possible and as much in dividends as possible and wipe out most of your Social Security tax.
Example: John has a net income of $80,000 from his S corporation. If he receives this amount in the form of salary, all of it would be subject to self-employment tax at the 15.3 percent rate, so he would pay $12,240. If, however, John pays himself a reasonable salary of $40,000 and takes the other $40,000 as a dividend, he would save 15.3 percent on the dividend, a savings of $6,120 each year that he does this! Not bad, huh?
You may be thinking that this sounds fabulous. Why not pay zero salary and take all the earnings as dividends and completely eliminate all self-employment tax? Unfortunately, the IRS has thought of this.6 The IRS requires you to pay yourself a “reasonable” salary. If you don’t, the entire dividend and undistributed portion of the net income from the S corporation will be reclassified as wages, which are fully subject to self-employment tax. Yuck! In fact, all taxpayers who didn’t understand this rule have ended up losing in court.
My favorite case involved an attorney named Joseph Radtke.7 Radtke thought the same way. He formed an S corporation and paid himself no salary. He treated the entire net income as a dividend. The tax court rightly reclassified the dividend as wages, and poor Radtke had to pay self-employment tax on the entire amount. Thus, you must pay yourself some reasonable salary.
What Is a “Reasonable” Salary?
Good question! The IRS defines “reasonable compensation” as what would ordinarily be paid for like services, by like enterprises (similar in size and business to your own), under like circumstances.8 This is generally interpreted to mean “what you would pay an outside agency or person to do the same duties.”
There are a lot of factors that determine what is reasonable, such as:
• Actual services performed
• Responsibilities involved
• Time spent
• Size and complexity of the business
• Prevailing economic conditions
• Compensation paid by comparable firms for comparable services
• Salary paid to company officers in prior years
Sadly, as you can see, the factors are not very clear. I would highly recommend that you check with a good accountant or tax attorney when setting any salaries and bonuses for you. Get comparable salaries from government publications.
Author’s note: Most people want a nice flat number or a flat percentage of income as the litmus test for reasonable compensation. Sadly, I can’t give a number, because it varies from business to business and according to a number of factors. However, from the many cases that I have read, I have found that in most cases where salary paid was approximately between 40 percent and 60 percent of net income, this amount has been deemed reasonable.9 Also, if there are unrelated minority stockholders, if they approve some compensation for the officers who are also majority stockholders, courts tend to give weight to this approval from the Board of Directors or stockholders, since the minority stockholders would then be receiving less in dividends.10 The bottom line: check with a good accountant and tax lawyer about setting any salaries and bonuses in order to minimize your salary and minimize your self-employment tax. Here, an ounce of prevention is worth a bundle in wealth!
Summary
• This strategy is especially great for Middle America.
• S corporation salaries and bonuses are subject to self-employment tax.
• Dividends and undistributed earnings (which are treated as dividends) are not subject to self-employment tax.
• If you’re an S corporation, pay yourself as little as possible in salary, as long as it’s reasonable, and as much as possible in dividends.
• Use a good accountant and/or tax attorney to help you establish what a minimum reasonable salary should be. Failure to do this would be a hazard to your wealth.
Notes
1. Section 1374(a) of the IRC. This deals with built-in gains where you have accumulated earnings and profits for a regular corporation. If you started as an S corporation and never operated this entity as a regular corporation, this is not an issue.
2. Section 1363(a) of the IRC.
3. Section 1366 of the IRC.
4. Section 1366 of the IRC.
5. Section 1402(a) of the IRC.
6. Revenue Ruling 74-44, 1974-1 CB 287.
7. Joseph Radtke v. United States, 895 F.2d 1196 (7th Cir. 1990).
8. Section 1.162-7(b) of the ITR.
9. Hamilton and Co., T.C. Memo 1959-153.
10. Gilles Frozen Custard, Inc., T.C. Memo 1970-73; William J. Hertz, T.C. Memo 1998-210.