S corporations provide tax-planning opportunities for service providers and self-employed individuals, including consultants, developers, designers, writers, instructors, or professionals in the fields of law, medicine, engineering, or accounting. Service providers and self-employed individuals can use LLCs taxed as S corporations to both avoid double taxation and save self-employment taxes.
Why Self-Employed Service Providers Need Customized Business Planning
Both LLCs and corporations may elect to be taxed as S corporations, and they often do so to avoid double taxation. But subchapter S provides an additional planning option for LLCs: Electing to be taxed as an S corporation can save LLC owners self-employment taxes they would otherwise owe. This article explains how LLC owners can use this strategy to save taxes on self-employed income.
What Are Self-Employment Taxes?
Self-employment taxes are taxes on individuals that work for themselves. Self-employment taxes are paid to the Social Security Administration and reported on Schedule SE of the owners’ tax returns. Self-employment taxes are authorized by the Federal Insurance Contributions Act (FICA) and are sometimes called FICA taxes.
The self-employment tax includes three parts:
- Social Security Tax. The social security component is 12.4 percent of a taxpayer’s earnings, up to the social security wage base. The social security wage base for 2019 is $132,900, meaning that taxpayers pay a 12.4 percent tax rate on the first $132,900 of self-employment income.
- Medicare Tax. The Medicare tax is 2.9 percent of self-employment income, with no cap.
- Medicare Surtax. Taxpayers pay an additional 0.9 percent Medicare surtax on the amount that their annual income exceeds $200,000 for single filers, $250,000 for married filing jointly, and $125,000 married filing separate.
The cumulative effect of these rules is to tax the first $132,900 of income at 15.3 percent (12.4 percent social security tax plus 2.9 percent Medicare tax). After $132,900, the social security tax drops away and all income over $132,900 is subject only to the 2.9-percent Medicare tax until income reaches the Medicare surtax threshold, at which time all income is taxed at 3.8 percent (2.9 percent Medicare tax plus 0.9 percent Medicare surtax).
How to Save Self-Employment Taxes with S Corporations
Under the default rules, the Internal Revenue Code taxes LLCs with more than one owner (multi-member LLCs) as partnerships and disregards one-owner (single-member) LLCs. In each case, all the LLC’s net income is passed through to the owners and subject to self-employment tax.
Even though LLCs are either disregarded or taxed as partnerships by default, they may elect to be taxed as S corporations. S corporations offer a unique advantage over the default classification. Unlike partnerships or disregarded entities, an S corporation can pay both salaries and dividends to its owners. Although both salary and dividends are taxable to the owner as ordinary income, only the salary component is subject to self-employment taxes. The portion paid out as dividends escapes self-employment tax.
The ability to divide compensation into salary and dividends provides planning opportunities. Savvy business owners can reduce self-employment taxes by characterizing more compensation as dividends (which are not subject to self-employment tax) and less as salary (which is subject to self-employment tax). This strategy—which we will call the divided-compensation strategy—allows owners of S corporations to pay less taxes than owners of other pass-through entities.
The Reasonable Compensation Standard
With self-employment taxes as high as 15.3 percent, the ability to avoid self-employment taxes by characterizing income as dividends creates a powerful incentive for owners to take low salaries and take more compensation as dividends. The IRS knows this loophole. To close it, the IRS requires owners to be paid “reasonable compensation” for services provided to an S corporation.
There are no bright-line rules for determining what the IRS considers to be a “reasonable” salary for an S corporation shareholder. The best guidance is IRS Fact Sheet FS-2008-25, which lists the following nine factors:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- Using a formula to determine compensation
The owner-employee of an S corporation need not be paid any minimum or maximum amount, only what is considered “reasonable” salary for the services provided. If the IRS determines that an owner-employee of an S corporation is taking dividends from the business and receiving a salary that is unreasonably low, the IRS can recharacterize the dividends as wages and require the owners to pay self-employment taxes on them. If the IRS succeeds in recharacterizing income, the owner-employees may be responsible for back taxes, penalties, and interest.
Strategic Considerations for Using the Divided-Compensation Strategy
The divided-compensation strategy can provide excellent self-employment tax-saving opportunities, but there are potential downsides to consider.
More Tax Complexity
Once a business is taxed as an S corporation, it must prepare and file a Form 1120 for the business and a Form K-1 for each owner, every year. Since the business pays a salary to the owner-employee, it must also keep up with payroll accounting (usually through a payroll accounting service). The additional administrative burden and cost can mitigate the tax savings resulting from the divided-compensation strategy. Whether this will be a concern depends on how the entity would otherwise be taxed and whether it already uses a payroll service for accounting.
Increased Audit Risk
It is widely believed that filing as an S corporation opens the business up to a greater risk of being audited by the IRS. The rationale is that, because the IRS knows about the divided-compensation strategy, the IRS is more likely to look at S corporation tax returns to sniff out abuse. For years, tax advisors have cautioned that the increased audit risk may outweigh the benefit of the tax savings that the divided-compensation strategy offers.
Although increased audit risk is something to consider, evidence suggests that it is not as great of a concern as some may claim. IRS audits of all taxpayers hit a ten-year low of 0.59 percent in 2018; more than 99 percent of tax returns are never audited. The number is even lower for S corporations: Only 0.2 percent of S corporation tax returns were audited in 2018. The same number (0.2 percent) of partnership tax returns were audited in 2018, suggesting that S corporations have about the same audit risk as pass-through entities that do not permit the divided-compensation strategy.
The Social Security Wage Base Limitation
The divided compensation strategy is most beneficial when the salary component of the owner’s compensation is less than the social security wage base ($132,900). Because the social security tax has the highest tax rate (12.4 percent) of self-employment taxes, avoiding social security tax provides the greatest tax savings. Owners can save 12.4 percent in social security taxes on every dollar by which their salary is less than the social security wage base.
Once the salary exceeds the social security wage base, the ability to save social security taxes is lost (since all salary over the social security wage base is not subject to social security tax anyway). Although the owners can still save the Medicare tax and the Medicare surtax, there are no further opportunities to save social security taxes.
For large businesses, it may be impossible to reduce the owner-employee’s salary below the social security wage base. If the business earns enough income, and if the owner has substantial responsibilities, a salary below $132,900 may not be “reasonable” in the circumstances.
But even if the owner-employee cannot save social security taxes, the Medicare tax and Medicare surtax savings can be enough to justify the divided-compensation strategy. For example, an owner-employee that is paid a $300,000 salary will not save social security taxes since her salary exceeds the social security wage base, but she can still save 3.8 percent on dividends in excess of the $300,000 salary. If the business earns enough to pay $200,000 in dividends (in excess of the $300,000 salary), the owner will save $11,400 in self-employment taxes by electing to be taxed as an S corporation.
Determining Reasonable Compensation
The lack of clear guidance on what constitutes a “reasonable” salary deters some business owners from electing to be taxed as an S corporation. The concern is that the IRS will later determine on audit that the salary is too low and seek back taxes, penalties, and interest.
To help mitigate audit risk, business owners can use third-party data to support an owner-employee’s position that her salary is reasonable. There are many sources of information about reasonable compensation—including the Bureau of Labor Statistics, Indeed.com, and Salary.com. The best practice is to gather two or three sources of data, average them out, and use the average as the owner-employee’s salary.
For owner-employees that play a key role in the business, it may be difficult to match their job description to a comparable salaried position. In this situation, the best practice is to divide the owner-employee’s responsibilities into percentages that match the third-party data sources and use those percentages to calculate the owner-employee’s salary.
For example, if the owner-employee spends 30 percent of her time in marketing, and the data indicates that the average salary for a marketing coordinator is $50,000, then 30 percent of the owner-employee’s salary would be paid at a rate of $50,000 ($15,000). The remaining 70 percent would be paid at different rates, depending on the work that the owner-employee performs.
As with most issues involving “reasonableness,” adequate documentation is important. It is best to create a formal employment agreement between the owner-employee and the corporation. The employment agreement documents both the basis for the owner-employee’s salary and the contractual obligation of the business to pay that salary.
Reduced Social Security Benefits
Social security benefits are based on the social security wages paid over a person’s career. When an owner-employee of an S corporation lowers her salary to save social security taxes, she also reduces the amount she is paying into social security. Paying less in social security taxes now may reduce the amount that the owner-employee will receive later when she draws social security.
For most people, the possibility of reduced social security benefits is not a big concern. There are many ways to save for retirement outside of the social security system, which leaves money in the government’s hands government to invest and pay out later. Given the choice, most people would prefer to keep more of their income instead of paying it to the government to invest for them.
Lower Retirement Account Contributions
Most retirement account contribution limits are based on the contributor’s earned income. S corporation dividends are not included in calculating contribution limits. Lowering the salary paid to an owner-employee may reduce the amounts that the owner-employee can contribute to her retirement account. If the owner-employee would otherwise save taxes by contributing to a retirement account, the loss of that savings may outweigh the self-employment tax savings, leaving the owner-employee with a net loss.
Many lenders—including mortgage lenders—look at a borrower’s salary when determining whether to make a loan. Some worry that having too low of a salary may affect an owner-employee’s ability to obtain loans. This concern is also unwarranted. Most commercial lenders are sophisticated enough to look at total taxable income (and not just the salary component). Were that not the case, the owners of businesses that cannot pay salary to owner-employees—for example, owners of LLCs taxed as partnerships—could not obtain loans.
Effect of Business Size and Nature
An owner-employee’s salary is—at least theoretically—the amount attributable to the owner’s active participation in the business. Any dividends paid to the owner-employee are attributable to something other than the owner’s active participation in the business.
For example, assume that the business is a software development company with one owner. All business income is a result of the developer’s performance of services to the business customers. In this scenario, every dollar that the business makes is directly linked to the owner’s active involvement in the business. This clear connection can make it difficult to argue that much of the owner’s overall compensation should be paid out as dividends. The direct link between the business profits and the owner’s efforts limits the divided-compensation strategy’s effectiveness.
If we change the facts, though, the owner has a better chance of taking more compensation as dividends. Assume that the software development company receives recurring revenue from software it licenses to third parties. That additional revenue stream means that not all compensation of the business is attributable to the owner’s active participation in the business. Similarly, if the business employees 500 employees, at least part of the business income is attributable to the efforts of others and not merely to the owner’s active participation.
To qualify for taxation as an S corporation, the business must meet strict eligibility requirements. For example, the business will have more than 100 owners, international owners, or owners that are corporations or partnerships, the business will not qualify to be taxed as an S corporation. These eligibility requirements alone stop many businesses from electing to be taxed as S corporations.
How to Decide Whether to be Taxed as an S Corporation
The following four-step process can help decide whether an LLC should elect to be taxed as an S corporation instead of accepting the default classification as a partnership or sole proprietorship.
- Determine a Reasonable Salary. Using the process identified above, determine a reasonable salary for the owner-employee. This step is somewhat subjective and will depend on the owner-employee’s risk tolerance. The goal is to determine the amount that the owner-employee can comfortable defend if the tax return is audited.
- Calculate the Tax Savings. Calculate the tax savings resulting from electing to be taxed as an S corporation. If a reasonable salary is below the social security wage base, the shareholder-employee can save 15.3 percent of the difference between the salary and the social security wage base. If a reasonable salary is above the social security wage base, the owner can save between 2.9 and 3.8 percent of overall compensation, depending on whether the owner-employee would otherwise be subject to the Medicare surtax. Either way, quantifying the potential tax savings helps the owner-employee make an informed decision.
- Determine the Cost of Being Taxed as an S Corporation. The cost will usually include the lost tax savings from any retirement contributions that would be limited by the lower salary, as well as any additional administrative cost for filing additional tax returns and paying for payroll service.
- Compare the Tax Savings to the Cost. Compare the tax savings (Step 2) to the cost (Step 3) to decide whether the business should be taxed as an S corporation. If the savings are higher than the cost, then elect to be taxed as an S corporation. If it is close, or if there are no clear savings, the best choice is to remain under the default classification.
Although this calculation can require number-crunching, it provides the analytical framework to determine whether an LLC should elect to be taxed as an S corporation to save self-employment taxes.