Could S Corp Owners Be A Tax Target?

I have been advising owners of C Corps, S Corps, and LLCs, among others, for years and feel I can wade in on this.

Part of the issue here is political, with the government wanting to enlarge its tax-revenue base and with small business owners wanting to minimize taxes they pay.

Another part of the issue deals with the fairness of taxing pass-through entities such as S Corps and LLCs for employment taxes. Remember that such entities can consist of owners who are employees and also of owners who are not. When such entities make profits on their operations, they can keep the profits in the company to fund growth, they can distribute all profits to their owners, or they can keep part of the profits in the company and distribute the rest to owners. Whether the profits are distributed or not, they are treated as net income of the entity and are "passed through" for tax purposes to the owners of the entity, who in turn must each report their allocable share of such profits as a line item on their individual income tax returns and pay income tax on them accordingly. This is true of both employee owners and non-employee owners.

The idea behind a pass-through entity is that owners can escape the burden of a double tax that would otherwise apply on profits were such profits to be taxed once at the entity level and then again on their distributions to owners of the entity as dividends. This idea derives from old-style partnership law, which has always taxed partnerships in pass-through fashion, in contrast to corporate law, which has always taxed C corporations at the entity level and then again whenever dividends were declared and paid to shareholders.

The pass-through idea is good and bad for S Corp shareholders and LLC members. It means that income tax issues are much simplified and income taxes minimized. Since the imputation of profits to owners is automatic, whether or not profits are actually paid out to such owners, it also means that owners can incur phantom income, and have to pay tax on it, if profits are not actually paid out.

When it comes to employment taxes, however, the issue becomes more complicated.

The broad idea behind employment taxes is that anyone who earns wages or salary as an employee or who makes profits while working a business directly as a proprietor is required to pay into Social Security, Medicare, etc.

Current tax law penalizes LLCs in this respect because it imposes employment taxes on all owners of the business, whether they are employees of the business or not. In other words, it simply presumes that anyone who would set up an LLC would do so to work in it directly and, thus, should be required to pay employment taxes on any profits from that business.

The rule with S Corps is actually fairer in this respect. With an S Corp, owners employed by the business are required by law to pay themselves "reasonable" salaries for services rendered to the business. Those salaries are then taxed to such individuals directly as employment income and the individuals who receive them pay both income tax and employment taxes on the amounts received as salary. Any profits that are passed through to shareholders other than as salary/wages, however, are not subject to employment taxes. This means that non-employee owners of an S Corp will pay income taxes on their pass-through income but not employment taxes. It also means that employee-owners will pay both income tax and employment tax on their salaries but will pay no employment tax on amounts earned in excess of their salaries.

The gist of this article is to suggest that S Corp owners have systematically abused their position by understating the salaries they pay to themselves and using this as a way of avoiding employment taxes on their true income. The corrective, it is assumed, would be to subject all S Corp income to employment taxes as well as income taxes.

There is clearly an unfair disparity between the way S Corps and LLCs are taxed in this respect. However, it is not necessarily more fair to subject all S Corp income to employment taxes. Such a change would impose employment taxes on all non-employee owners of an S Corp and make them pay things such as Social Security tax on income that for them is purely investment income.

The problem here is an audit problem, given that the S Corp rules already use a theoretically fair system for deciding which aspect of a company's profits is fairly allocable to "employment" as opposed to "ownership."

How that problem is corrected, then, turns into a political issue. For those favoring the government's broad ability to tax away, it means closing a loophole. For those favoring the ability of small businesses to pay fair employment taxes tied to actual employment activity by owners, the current system is fine.

While it might be argued that the current system is abused, and hence that the current S Corp rules should be changed, a similar argument might be made about under-reporting of income by small businesses generally. The question is, because some cheat, should all be penalized? I tend to think not but, as I said, this becomes as much a political issue as anything else at this stage, and not a legal one. People will differ on the best resolution.

The problem is actually the opposite, that S-Corp is not a scam but LLC is a tax hawk. If your bootstrapped startup ever becomes profitability, you will learn quickly that taxation (with or without representation) is your number one cost (more than labor, more than sales and marketing). First you pay 15.3% self-employment tax, then 35% Federal tax, then 9.3% State tax (if you live in California) and finally 9.25% sales tax (if you live the Bay Area), that's 69% tax before net profit (necessary for rainy days). As my good friend Art once told me, everyone eventually becomes a "conservative", you just have to have something to "conserve" first. I immediately became a conservative when I saw profit and I believe you will too. If you want to avoid double-taxation (i.e., first tax as an individual, then as a Corporation), then you have two choices. You can form an LLC or you can form a S-Corp. The advantage of LLC is that there is a lot less legal overhead and there is no restriction with foreign ownership (this is a big deal if you happen to have a co-Founder who is not a US resident or citizen or if you have partners overseas). The problem with LLC is that ALL of your profits are taxed as self-employment income (15.3% off the top). On the other hand, with S-Corp, you do need to pay yourself a market-value salary (or you will be subject to audit so it is never a scam as some commenters would suggest). In my own experience, the optimal solution turns out to be that of forming your startup as an LLC but file a S-Corp (form 1120S). The following is a good read.

http://www.startupforless.org/2008/01/make-money-then-make-m...

They're not talking about "wringing more money out of the country's small businesses". They're shutting down a huge scam.

Sole proprietors, LLC owners, and partnership members pay self-employment tax, which replaces the employee and the employer's share of FICA.

Every employee in the nation pays FICA, whether they work at Starbucks or Goldman Sachs.

S-Corp owners elude this tax --- which everyone else has to pay --- by claiming unnaturally low salaries. Only the salary is eligible for self-employment tax. The remainder of the S-Corp owner's comp is disbursed directly as a distribution (think "profit-sharing"), and is for no good reason exempt from self-employment tax.

Whatever you may think of Social Security (Forbes: clearly not a fan), it is unfair that a shift manager at Starbucks should have to pay a tax that a 6-figure-income small business owner gets to walk away from.

I say this as the co-owner of a profitable small business.

" it is unfair that a shift manager at Starbucks should have to pay a tax that a 6-figure-income small business owner gets to walk away from."

Indeed, the shift manager should enjoy the same exemption.