Business Entity Basics Part III: The S Corp Wrinkle: The S Corp Can Save Owners Big in Self-Employment Taxes

By Andrew Randol - February 28, 2019 - Corporate & Business

In Part II of Business Entity Basics, our Columbus business lawyer explained that taxes are usually the primary factor when choosing between an LLC and a corporation. Business Entity Basics Part III discusses a third option that is often used in many small and medium sized businesses, the S Corp.

Why would you choose an S Corp Election?

Qualifying LLCs and corporations can elect to be taxed as a small business corporation or S Corp. S Corp taxation uses the same pass-through scheme as partnership taxation. However, one wrinkle in the law can allow S Corp shareholders to avoid some self-employment taxes. For those unaware, apart from income taxes, entrepreneurs are also hit with a 15.3% flat tax called a self-employment tax.

The self-employment tax covers the same federal government taxes as are covered by payroll taxes, such as Medicare and social security taxes. In an employer-employee relationship, the 15.3% tax is split evenly between the employer and the employee. In a self-employment situation, the entrepreneur is hit with the entire 15.3% tax.

However, the S Corp tax election can allow the owners to avoid some of these self-employment taxes. This is because of a minor difference in federal law as to what portion of profits constitute self-employment income under an S Corp.

Under partnership taxation, when a partner materially participates in the operation of the venture, the partner’s distributive share constitutes earnings from self-employment which are subject to the 15.3% payroll tax.[1] In the case of a two-member LLC, each partner pays the 15.3% self-employment tax on their $50,000 distributive share of the profits, in addition to ordinary income tax.

However, shareholders under an S Corp who materially participate in the venture can avoid a portion of 15.3% self-employment tax. This is because payments made to the shareholder as a dividend are not considered self-employment earnings.[2]

Thus, a shareholder of an S Corp who is materially participating in the business can, to a certain extent, avoid a significant amount of payroll taxes by dividing the shareholder’s income reasonably between compensation payments (self-employment income) and dividends (not self-employment income).

However, don’t attempt to be too tricky with this scheme and assume that shareholders of an S Corp can pay themselves entirely in dividends and avoid self-employment taxes entirely. The law requires the S Corp shareholder who is participating in the business to receive a reasonable salary, commensurate with the work being performed.

S Corporation Taxation Examples

For instance, suppose two dentists open their own practice using an LLC and they decide to have the LLC taxed as an S Corp in order to save on some self-employment taxes. Let’s assume for this example that a full-time dentist makes, on average, $100,000 per year. The dentists cannot simply pay themselves entirely in dividends in order to avoid self-employment taxes. They also cannot pay themselves what is clearly not a salary commensurate with their work. For instance, paying themselves a salary of $20,000 per year would obviously be inadequate, given the average salary of a dentist. However, let’s assume the dentist office made $400,000 in profits in its first year of operation and each dentist received $100,000 in salary for the first year of operation. Self-employment taxes would be assessed on this first $200,000. The remaining $200,000 in profits could be distributed to the dentists as dividends. This $200,000 will not be subject to the 15.3% self-employment tax, thereby saving the dentist $30,600. If the LLC was paying taxes as a partnership, then the entire $400,000 would have been subject to self-employment taxes.

There are several limitations to electing to be taxed as an S Corp, including types of shares the S Corp may issue and who can own those shares. However, those limitations are best left to another Latest Thinking post.

Ultimately, selecting the best business entity for your business and making the best tax election is a complex decision based upon the business, its owners, and the goals of the company. This decision is best made with the advice of a Columbus business law attorney and accountants. Our Columbus business lawyer will take the time to understand your business needs, in order to advise you on choosing a business entity and making the correct tax election for the business.

[1] See 26 USC § 1402(a). This is assuming that the partners materially participate in the operation of the business.

[2] See 26 USC § 1411.