Tax Memo – Is Your S-Corp Saving You Taxes or Helping Evade them?

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First, there are business coaches and consultants spreading a myth. That myth states that if you incorporate or form an LLC you can take more expenses than if you stayed a simple sole proprietor.

This is untrue! Regardless of the type of entity you have, you can take any and every valid business expense. These phantom expenses do not exist.

Be wary of these supposed coaches and consultants. They promise to bring you to the “next level.” Many of them are former executives who have been fired, or as they like to more kindly say about themselves, that they made a “career change.” 

If you have a business question or tax question, or if you are worried about the “level” you are currently on and want to get to the next one, I should be your first call. I help run 100s of businesses each and every day.

Now that that is out of the way…

One of the main questions I get on a daily basis, is, should I set up an S-Corp or a single member LLC?

Most times this question is asked because people have read or heard that forming an S-Corp instead of an LLC will in some way save them money, on both the phantom expenses that don’t exist described above, AND also on taxes.

The taxes in question here are NOT ordinary income taxes, but on what are called self-employment taxes or FICA.

So, with regard to this, let me explain exactly what this faulty thinking is and then we’ll get to answering the question that this memo is asking “Is your S-Corp saving you taxes or helping evade them?”

We all have worked for people and have gotten a W-2. On those pay stubs for those jobs you’ll see deductions for Social Security and Medicare. These two deductions are called FICA, and they total 7.65% of your gross wages.

Most people don’t know that your employer has to match that FICA when they pay their payroll taxes at the end of the month. So, FICA, really totals 15.3%, 7.65%, the worker, and 7.65% the employer matches.

Now, when you’re a self-employed person both parts of FICA/Self-Employment Tax still have to be paid, and you, the owner, need to pay both sides of that on your net income. For a self-employed person, the amount paid is slightly less than the total of 15.3% paid by employees/employers. You will see how this is calculated in my comparison spreadsheet below.

So how did this lead to the question about being an S-Corp or being an LLC? Well if you are a sole member LLC you will pay FICA/Self-Employment Tax  on your net income for the most part.

So let’s say that you earned $100,000 as a sole proprietor running your LLC. Your FICA/Self-Employment Tax on that would be $14,130. Yes, this is less than the 15.3% total paid by the S-Corp. But you will see there is an adjustment to the FICA/Self-Employment tax paid by a sole proprietor.

I hope this makes sense to everybody so far.

Now let’s say though that you want to become an S-Corporation.

There are two main types of income an S-Corp owner can take, wages and dividends. The most important difference between these two income flows to you, the owner, is that dividends are NOT subject to FICA/Self-Employment Tax.

So that means you would have a W-2 from your own company, the S-Corp, the way you would from other companies you have worked for.

Let’s say that you earned $100,000 in an S-Corp instead of the LLC. Many CPAs use an arbitrary 60/40 rule and would tell you to pay yourself $60,000 of wages and take the other $40,000 as a profit flow through or dividend. Why would they do this? Because profit flow through and dividends are not subject to FICA / self-employment tax.

So that looks like a great deal doesn’t it? That means that you’re going to avoid paying FICA on $40,000 where if you were a sole proprietor you would be paying the FICA on that.

That would be saving you $4,950 as shown in the chart below. That sounds fantastic!

But There are problems with this that many people don’t realize.

There are special IRS rules that are called reasonableness in compensation rules which basically state that the money that you take as wages out of out of an S-Corporation need to closely match the earnings you actually have.

This excerpt is taken from an IRS audit manual on the subject. The specific scenario I am discussing in this memo is noted here. The full text can be found at this link.

https://tinyurl.com/ycmho6a6

3. SUBCHAPTER S-CORPORATIONS Compensation can be an issue with respect to a corporation that has elected to be taxed under the provisions of Subchapter S. …… The more likely scenario is that a lesser amount will be identified as compensation in order to avoid paying payroll taxes with the remaining amount treated as owner distributions. In these cases, by determining what a proper level of compensation should be, a Valuation Analyst may make the appropriate allocation between amounts subject to payroll tax and amounts not subject to payroll tax.

Getting back to our example above you actually earned $100,000. You didn’t earn $60,000.

Also think about it. $40,000 as a dividend? Meaning 40% of earnings being given as a dividend? Even the best Fortune 500 companies don’t go above 3 or 4 or 5%.

Many CPAs will sell this “strategy” as they call it, and make people believe that it’s reasonable and that it’s something the IRS has mandated or that the IRS would bless.

This is the farthest thing from the truth. Having such a low amount of W-2 earnings and a high amount of profit flow through or dividends from an S-Corp is tantamount to tax evasion.

Most sole owners of companies could really be an LLC and don’t need to be an S-Corporation. The only reason why many S-Corporations are created is to try to evade this FICA/Self-Employment Tax tax and to increase the amounts they pay their accountant at year end.

Don’t get me wrong, the larger your organization, the positive reasons for forming an S-Corp or over an LLC are real and worth considering.

Are you an owner of an S-Corporation? Have you truly taken a look at the breakdown between the wages you’re taking and profit flow through or dividends you’re taking?

Don’t forget that your accounting fees will be higher at year end if you’re an S-Corp. As an S-Corp needs to file a separate return called an 1120S and then you still need to have your personal 1040 filed. So this gives an extraordinary extra amount of work to the accountant. Additional costs would be payroll, as an S-Corp owner needs to take wages, and not a simple draw a sole owner of an LLC would.

So I urge you to take a look at how your income is being reflected from your S-Corporation to see if the split between your wages and what’s flowing through as dividends or net income, which in this case are the same thing, are reasonable.

The rule of thumb out there is a 60/40 split as in my example above, but this is outrageous and would never hold up under an IRS audit. Again the money you’re earning in these situations are your earnings from business. You don’t have a dividend coming, unless you have excessively above average income for your industry/profession.

This chart below gives a good breakdown and comparison. Please note that these tax calculations have been simplified and the actual tax calculations would be much more involved.

Now, in our example we have $100,000 income from the business

I’m showing you how this is presented on your tax return both as a sole member LLC filing a Schedule C or an S-Corp that would be giving you wages and some dividends or profit flow through.

In both of these examples we’ll see that you have $100,000 of total income or adjusted gross income.

The big difference appears underneath adjusted gross income when we are going to calculate the taxes.

We assumed a 20% income tax rate here so ordinary income tax is $20,000 for each.

The difference comes in when we deal with the FICA/Self-Employment Tax. As I explained above the employee of the S-Corporation, in this case the owner, will have half of the FICA withheld on a W2 and his S-Corp which is the employer, will also pay the other half. This equals 15.3%.

But if we look at how they split the income on the S-Corp only $60,000 went towards wages which means that we only pay the FICA on $60,000.

So let’s compare that to the tax treatment if you remained a sole member LLC filing a Schedule C as a sole proprietor.

The total amount of self-employment tax paid on the LLC filing as a Schedule C is $14,130. On the S-Corp side we’ve only paid $9,180 will you being a possible shortfall of $4,950.

Technically, all of the money that you’re making from a single owner LLC or S-Corporation is all earned income and technically subject to FICA. Yes, the IRS is overburdened and many fall under the radar.

If you do have an S-Corp I urge you to look at how your CPA is structuring your compensation and the related flow through to see if it’s truly reasonable.

Please don’t allow them to say that this is how it’s done or this is acceptable in the industry. Many things that are done or acceptable in industries are not within the law!

Of course, I’m aggressive as anybody but I don’t like to be stupid, especially when the potential liability will come out of their wallet

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