Are you paying too much in SE Tax?
Discharge of Indebtedness
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John Tatoian
Attorney & Counselor At Law
150 Harbour Close
Unit 306
 New Haven CT 06519 

Worldwide Cell:(860) 490-4138

United States District Court of Massachusetts, United States District Court of Connecticut & the State Court of Massachusetts

Are you paying too much in SE Tax?

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.

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 – are 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.

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

The 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.In the logical extreme, then, an S corporation owner should want to pay nothing out as salary, and everything out as a dividend distribution. Since any/every dollar would save a minimum of 2.9%, and as much as 15.3%!

Recognizing this, though, the IRS still prevents a shareholder-employee from completely avoiding employment taxes, by requiring S corporation owners to be paid at least “reasonable compensation” for their actual services rendered to the business. In fact, for more than 40 years now – since Revenue Ruling 74-44 – the IRS has been imputing implied wages to owner-employees who fail to pay themselves reasonable compensation (i.e., recharacterizing their dividend distributions as wages, and applying FICA taxes accordingly).

In other words, if the S corporation earns $400,000 of profits, but the owner-employee did work that would have cost $100,000 for another employee to be hired to do it instead, then the owner-employee must report at least the $100,000 of “reasonable” compensation that would have been paid for that position (and only take the remaining $300,000 as a dividend distribution).

Notably, the exact determination of what constitutes a “reasonable” compensation is ultimately based on the facts and circumstances of the individual owner-employee. IRS Fact Sheet FS-2008-25 notes that relevant factors include the person’s training and experience, duties and responsibilities, time and effort devoted to the business, compensation to other (non-shareholder) employees, what comparable businesses pay for similar services, and more. Or stated more simply, as the name implies, the owner-employee doesn’t have to be paid the ‘maximum’ possible, nor any minimum specified amount; instead, the compensation must simply be “reasonable” for the services rendered. But clearly $0 of salary (and 100% of S corporation dividend distributions) is not reasonable compensation for an active owner-employee involved in the business!

Notwithstanding the fact that the tax code requires an S corporation to pay “reasonable compensation” to an owner-employee, in many (or even “most”) cases, an S corporation would still not have to pay all of its profits out as wages subject to employment taxes.

Classifying 100% of S corporation profits as salary might be necessary for a sole owner S corporation with few or no employees, since in that context virtually every dollar of profits really is attributable to the active employment efforts of that owner/employee. But in “larger” businesses with multiple owners and/or employees who all contribute to the value of the business, at some point of the profits of the business are not just a function of the owner/employee, but also of the value of the business itself. That could be value created from the services of non-shareholder employees, or from the capital/equipment of the business – both of which the IRS recognizes as being part of the profits of the business, and separate from reasonable compensation of the owner-employee themselves. Or viewed another way, the whole point of differentiating dividend distributions from salary or other wages is that the latter is a reward for working in the business (and subject to FICA taxes), while the former is the financial reward for creating a profitable business in the first place (and not subject to employment taxes).

In practice, this means that owner/employees will often “split” their total share of the profits between taxable salary wages (subject to FICA taxes), and S corporation dividends that are exempt from FICA taxes.