A majority of American small businesses use the S corporation form of doing business.
This article discusses one of the main tax planning techniques an S corporation can use to save taxes.
The S Corporation and Payments to Shareholder/Employees?
An S corporation is a pass-through entity and does not pay federal income tax.
The net earnings of the S corporation are passed through to the shareholders of the company and reported on their individual income tax returns.
Typically, an owner of stock in an S corporation also performs services for the company making him, in addition to an investor in the company, an employee of the company.
So what is the proper tax treatment of monies that are paid from business profits to the S corporation investor/employee?
Setting aside payments from the S corporation to the investor/employee that are loans, repayment of loans or returns of capital previously invested by him, there are two categories of payments to the investor/employee:
- Wages; and
- Shareholder Distributions.
Here is how each category is treated for tax purposes:
Tax Treatment of Wages – Wages paid to an investor/employee of an S corporation are treated like wages paid to any other employee.
Federal withholding and FICA taxes are withheld from the investor/employee’s paychecks in accordance and the investor/employee receives a net check at the end of every pay period.
The S corporation must “match” and pay over to the IRS an amount equal to the FICA portion of the tax withholding.
Under current law, the employee is required to pay (and have withheld) 7.65% of his wages toward Social Security (6.2%) and Medicare (1.45%). This means the S corporation must also pay over to the IRS, out of its own funds, 7.65% of the employees wages.
(Note: In 2009 the Social Security part of the FICA tax only applies to wages up to $106,800)
The combined FICA remittance, then, is 15.3% (2 x 7.65%).
The S corporation is entitled to deduct the amount of gross wages it pays to its employees, including its investor/employees, in determining the amount of net income that will be passed through and taxed on the S corporation’s shareholders’ returns.
The S corporation issues a form W-2 to the investor/employee and the investor/employee must include the wages on his federal income tax return.
Tax Treatment of Shareholder Distributions – Shareholder distributions are treated differently than wages because they are deemed to be a return on the investor/employee’s investment in the S corporation and not compensation for services rendered.
Distributions to a shareholder must be included in the shareholders taxable income; however, the distributions are not subject to FICA tax and are not considered self-employment income subject to self-employment tax.
No W-2 or 1099 need be issued by the S corporation to the shareholder and the S corporation has no FICA matching requirement since no FICA tax is due.
Here are two examples that illustrate the differences in the tax treatment of wages and shareholder distributions:
Example #1 – All Wages and No Shareholder Distributions
Capone, Inc. is an S corporation. It has one shareholder who also performs services for the company.
In 2009, the S corporation pays $80,000 of wages to it’s sole shareholder and zero shareholder distributions.
Here is the FICA calculation for the wages paid to the shareholder:
- Withheld from shareholder (investor/employee): $ 6,120 (7.65% x 80,000)
- Employer matching (paid from S corp funds): 6,120
- Total FICA tax paid: $12,240
The S corporation will issue a W-2 to its shareholder in the amount of $100,000 $80,000 and the shareholder must report that as income from wages on his personal tax return.
Example #2- 50% Wages and 50% Shareholder Distributions
Same facts as Example #1 except that Capone, Inc. pays $40,000 of wages to its sole shareholder and $40,000 of shareholder distributions.
- Withheld from shareholder (investor/employee): $ 3,060 (7.65% x 40,000)
- Employer matching (paid from S corp funds): 3,060
- Total FICA tax paid: $6,120
The shareholder gets a W-2 for $40,000 and reports that as wages on his return. The $40,000 of shareholder distributions is reported on Schedule E (PDF) of the return and is not subject to self-employment tax.
By shifting $40,000 from wages to shareholder distributions there is a tax savings of $6,120.
The above examples show that for every dollar (up to the Social Security wage limit of $106,800) that is shifted from wages to shareholder distributions there will be a savings of 15.3%.
An investor/employee wears two hats: First, he is an investor who is entitled to expect a return on his investment. Second, he is an employee who performs services for compensation.
Consequently, it makes sense that there be some apportionment between what the shareholder is paid for his services and how much he receives as a return on his investment.
However, there is much abuse in this area of tax planning and taxpayers should consult their tax advisors before determining how to apportion payments between wages and shareholder distributions.
In the last decade the IRS has promised to select S corporation returns for audit based on this issue, but I have not yet seen or heard of a case where the IRS selected an S corporation return for audit based on this issue alone.