H.R. 4213 - Payroll Tax for S-Corp Dividends | Hacker News Reader

H.R. 4213 - Payroll Tax for S-Corp Dividends

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23 pointseuroclydon33 comments

GOOD. The dividend/payroll split trick that S-Corps play is a huge scam.

Normal people in normal jobs --- hell, ace (non-founder) devs at startups taking W2 wages --- have most of their income subject to payroll taxes (most notably FICA). These taxes are a significant chunk of all your withholdings.

However, if you and your partners own an S-Corp, you can choose to pay yourself not only in direct wages but also as cash distributions (think "profit sharing"). Unlike wages, distros are not subject to payroll taxes. You can skip out on your FICA payments for all the income you elect to pay as a distro.

In an LLC, all of a company principal's income is paid as distros (you can't formally be an LLC principal and take W2 wages). But that income is all subject to self-employment tax. It's only in the weird little blip between LLC and C-Corp that this tax avoidance trick exists.

There is no legitimate reason why an LLC principal should have to fully fund Medicare and Social Security, and a C-Corp director should have to fully fund Medicare and Social Security, but an S-Corp shareholder should be able to carve out some (or even most) of their income to avoid those taxes.

To my eyes, this is a loophole in the purest sense of the word, and I'd be happy to see them kill it.

The big reason people do an S-Corp is to avoid double taxation (and to be a corporation rather than LLC while not having the complex structures of a C-Corp). Better than being a sole proprietor. Keep in mind that S-Corps can only have a certain number of shares and shareholders (100?) in one class of stock, so a startup or large corporation can't be an S-Corp and take advantage of the tax benefits. Also, here in California, all corporations (S and C and even LLC) owe tax even if the company's net income is zero.

Um, I'm not a CPA, and I definitely don't know how California taxes work, but at the federal level, isn't that (taxation at the corporate level) pretty much the opposite of how an S-Corp works?

An S-Corp just avoids double taxation. Salaries paid out are subject to FICA. As for the remaining business income, each shareholder would still owe taxes based on how much of the business they own. This is different than a C-Corp where the business income would be taxed at the corporate level in addition to the owners paying income tax on their salaries. And if the owners of a C-Corp decided to pay themselves huge dividends to avoid normal income taxation, that would raise red flags.

In California, S-Corps pay a 1.5% franchise tax on net income (minimum $800). You pay this even if your net income is zero or negative. You pay this no matter what.

Disclosure: I'm also not a CPA.

Yeah, Alex, I'm just saying: S-Corps don't pay federal corporate taxes, do they? I thought that was the point of an S-Corp. Your comment, before you edited it, said flat-out that they did.

(We file as S, but thankfully I'm not the person here that has to know exactly how this stuff works. See previous comments for evidence that you should not take tax advice from me.)

Right, yeah, looks like S-Corps don't pay federal corporate taxes. I knew it was to avoid double taxation but I had forgotten which taxation S-Corps were exempt from. My bad. Unfortunately, for California, you owe the 1.5% (minimum $800) franchise tax on company income whether you're an LLC or S-Corp or C-Corp. In NYC, you are subject to the full corporate income tax rate, even as an S-Corp.

That explains why I suddenly had to start paying NY taxes, even though I live in Illinois (we started filing differently).

Sure ... but what does that have to do with dodging FICA taxes, which are not the double taxation in question?

And people absolutely do pay themselves ridiculously low wages and take the rest in profit, and choose S-Corps specifically in order to make it possible. The incentive is too big: Pay yourself 100k in salary out of your 100k total? Or 50k and take the other 50k as a distribution, saving 15% on it along the way?

Hey Thomas,

I've been thinking about something philosophically for a while, and you're one of my favorite posters on the site and we agree on a heck of a lot of stuff, but we've got split opinions on taxation. Would it be alright to ask some kind of difficult questions philosophically on the matter? I want to understand what you think. These aren't easy questions:

Would you willingly pay your taxes if you believed the money was going to an illegitimate government that is doing bad and destructive things with it?

There's an easy answer to that that kind of avoids the question, which is, "Regardless of my personal feelings, governments can, will, and should go after people who try not to pay." And okay, sure, that's reality, I'm looking more philosophically.

Going a little bit further, do you think it makes a difference whether the government is a democracy, as opposed to, say, a totalitarian state or a theocracy?

And final question - what if you're in a democracy, but the people have been mis-educated as to what's actually happening by the official government? For instance, imagine North Korea switched to an actual, real, voting democracy tomorrow, no secret police, no Dear Leader any more. But they've still gotten mis-educated and brainwashed for all their formative years. Is their will morally binding on each other for setting state policy? Is it morally binding on you, no matter what, even if you disagree with it?

I guess these are hard questions. I've thought about them. I've got my answers and am happy to share, and happy to answer hard questions in turn if you like. I think this could be a good discussion because you're bright and I respect you a hell of a lot and would like to hear what you think on this - our feelings on the matter seem to be far apart, and I'm kind of curious to figure out where our beliefs start diverging to get to the end conclusions.

-Sebastian

I think the general principal in play here is fairness. I think fairness is orthogonal to the government's use of proceeds.

If my best developer has to pay more taxes than me, simply by nature of not owning a portion of the company large enough to funnel her wages through, that situation seems prima facie unfair. The unfortunate fact is, that same unfairness is usually going to be compounded: my ownership of the company that developer works for probably means I'm not only paying relatively lower taxes, but also making more money. That's regressive. Regressive taxes are evil regardless of whether you think progressive taxes are good.

Finally, I actually don't think the use of proceeds issue makes this a harder call. Forget totalitarian states for a second, and just think about Social Security.

A rationale for not paying taxes is that they'll go to fund a sham Social Security system. But if Social Security is a sham, it's wrong that anybody should have to pay into it. Moreover, as long as most people are on the hook for it, shielding yourself (and the class of people like you) from its obligations is actually counterproductive. The more people (and the more influential the people) affected by FICA, the more pressure there will be to change that system to reflect the will of its stakeholders.

> A rationale for not paying taxes is that they'll go to fund a sham Social Security system. But if Social Security is a sham, it's wrong that anybody should have to pay into it. Moreover, as long as most people are on the hook for it, shielding yourself (and the class of people like you) from its obligations is actually counterproductive. The more people (and the more influential the people) affected by FICA, the more pressure there will be to change that system to reflect the will of its stakeholders.

That's actually a very intelligent argument. For the record, I do pay my taxes and I'm not particularly creative or aggressive about it - but I do it with roughly the same feeling I give my wallet to a mugger if he's got a knife.

The alternative argument is, "If something is bad, less of it is always good." Like, in a place that arrests people for free speech, should every free speaking person turn themselves in? But your position also makes sense as well, seems to be thought out, and part of a coherent worldview. I disagree, but I appreciate you taking the time to respond. Cheers.

If something is bad, less of it is always good.

The problem with this statement is that very few "things" are either all good or all bad.

P.S. You both make good points and it's encouraging to see thoughtful discussions like this on what can be very divisive issues, so thanks.

Correct me if I'm wrong, but because the person is not paying into those taxes, they also will lose out on social security benefits when they are older. So it's not a total free lunch.

No, you're right. It's just mostly a free lunch.

> you can't formally be an LLC principal and take W2 wages

That's incorrect. An LLC can file as an S-Corp and the partners can take W2 wages.

That's what we do, but is an exception that somewhat makes my point for me.

So would you be for sales tax on services too?

"The bill slowly poisons many s corporations."
[...]

"I’m not alone in my concern over the scope of this bill and what it means for our economy. We keep pushing a little bit at the edges of some pretty sweeping changes at an alarming speed – so fast, in fact, that many taxpayers haven’t had time to digest them, much less, react to them."

A general term for this is "regime uncertainty." People continually complain about a corporate focus on the next quarter while not noticing that major tax and other business law (e.g. SarBox) changes every couple of years makes it well neigh impossible to do long range planning.

Things have been quite a bit worse lately and as long as Team Obama and the Congress continue to move at ramming speed a lot of economic activity is going to be suppressed until many months, probably more than a year, pass so that people can digest the changes and their implications.

If you were playing the S-Corp distro game, my understanding is that you were already living in a world of uncertainty, because (a) paying out distros that are large relative to your wages is an audit flag, and (b) the IRS already has the authority to retroactively decide what fair market value for your company role is and then whack you for the money you tried to stash in distros.

People do it anyways because everyone is unlikely to get audited almost no matter what they do. That doesn't mean that closing the loophole is going to throw people's tax planning in to chaos. You opt for chaos when you decide to cheat.

Playing the "S-Corp distro game" is not cheating.

If an S-corp brings in, say, several hundred thousand dollars in net profit and the principal pays themselves a fair wage for an employee in that role (perhaps it's in the neighborhood of $80k - $150k), then that is completely legitimate under current law.

Aggressive but correct tax planning is not cheating, and for a responsible business owner who wants to maximize personal income (and ability to reinvest in the business), it's the way the game should be played.

I agree, but what's your point? If you're getting ~90k in wages, the rest of your income isn't subject to FICA anyways.

(That may soon change, with talks of lifting the caps on payroll taxes, and that's a change I'll be far more ambivalent about).

I admit, that point had not occurred to me. Nevertheless, the Medicare portion isn't subject to a cap.

My main issue was this: "You opt for chaos when you decide to cheat." Aggressive tax planning within the bounds of the law is not cheating, and I think it's unfair to characterize it that way.

The wage/distro setup is an advantage unique to S-Corp owners, and I understand why some want to see it eliminated. But to use it today is not cheating.

The courts appear to disagree with you. "Aggressively" characterizing a portion of your income as a distribution when it is really just disguised wages appears to be a losing proposition, except for the fact that you're probably not going to get audited (as long as you pay yourself a relatively significant amount as bona fide wages).

A tax planning strategy that relies on never getting audited, and that fails spectacularly when you do get audited, I think can reasonably called "cheating". I get that reasonable people can disagree on this, and I'm fine with reasonably disagreeing with you.

By "aggressively within the bounds of the law", I was suggesting that the IRS's position and court's position was already taken into consideration (not just the low chance of being audited).

Regardless, surely it's possible to have situations where distributions are legitimately greater than zero. If I'm an absentee owner who pays a manager to operate my business, my distributions shouldn't be treated as wages.

I see it as a continuum -- on one end, you have cheaters who are paying themselves $10k annually and taking the rest as distributions. On the other end, you have absentee owners who should legitimately be able to claim distributions. In the middle there are many shades of gray.

Here we converge on agreement. Thanks for your patience.

Today, an s-corp founder does benefit by being able to split his/her income between W2 wages and distributions (on which payroll taxes don't need to be paid). Besides increasing tax burden, this bill will also make the tax-filing process a bit more cumbersome for s-corp founders.

If HR 4123 goes through, the tax-benefit will be removed for S-corp founders. However, venture capitalists (with carried interest income), perhaps some LLC founders (who don't take W2 salaries) will still be exempted from payroll taxes.

Unfortunately, as part of payroll taxes, s-corp founders are required to pay unemployment insurance taxes that they can never benefit from. For example, I'm required to pay FUTA taxes when I get W2 wages, yet I cannot claim unemployment allowances if my company doesn't make money in a given month.

If they're talking about closing loopholes, I think they should close the reverse-loophole that lets the fed govt collect unemployment taxes without providing any unemployment benefits. My state (WA) exempts corporate officers from paying unemployment taxes, but that just means that I pay even higher FUTA taxes to the the federal govt.

You have in reality no such benefit. From my cursory research, taxpayers have consistently lost every case in which they attempted to hide wages as distros. Courts have held that "wages" is a term that describes all remuneration for services rendered in any form. Even loans from the company to shareholders can, under the tax code, be reclassified by the IRS as FICA-eligible wages.

The only benefit S-Corp shareholders have under the present system is that they can force the IRS to audit to recover this money, which is a game that entrepreneurs often win because very few people really get audited anyways.

So, two things. First, the loophole doesn't really simplify your life. For many years after filing one of these bogus returns, you can still be levied for the hidden wages, plus penalties (including a huge extra negligence penalty). Second, there's nothing fair or sensible about the exemption S-Corp shareholders are taking; people with exactly the same skin in the economy have to pay FICA, so why shouldn't S-Corp owners?

You're making the assumption that all S-corp distributions amount to "hiding wages". Most accountants will tell you that IRS regulations disagree with you on that point.

I see that you didn't respond to the reverse-loophole point on FUTA taxes. Why should a company pay unemployment insurance taxes for founder-employees when these employees can never claim unemployment allowances ?

The general line of argument would be that FUTA payments fund a broad social safety net, and that no "insurance" payment we make to the government has implied 1:1 benefits for the payers.

But we don't have to bother with that argument because I agree with you on that point.

The general logic of the tax code and the IRS' enforcement of it seems to be that as an employee of a company --- which you are unless there's some patently obvious reason why you would be performing services for the company otherwise --- then your role has a fair market value. If you make at least that amount of money in any way, you owe payroll taxes on it. Over that amount, you don't.

The reality of the software business is, if you're a principal, founder, officer, director, or lead at a company that can afford to distribute tens of thousands of dollars to its employees, your fair market value is probably greater than the FICA cap, and the notion of what "is" or "isn't" a distribution is academic.

Are there scenarios where people are legitimately taking profit sharing distros that are not, under the spirit of the tax code, wages? I'm sure there are. Do those scenarios really account for a significant fraction of the cases where people take a "wage/distro split"? I really doubt it. My casual sense of it is, people that take a "wage/distro split" feel entitled to pay lower taxes simply because they've finagled themselves into an S-Corp.

First of all let me point out that employees who are not business owners do NOT have to pay in the full 15.3% (SS & Medicare) to the government. Only 1/2 of that gets taken out of their paychecks. The other 1/2 is paid by the employer (social security wage base is $106,800 and unlimited for medicare). Also, in most states employees do not have to pay into unemployment. The employer pays into that for them. They also usually get vacation/sick pay and health insurance benefits. A one owner S Corporation has to pay in the full 15.3% on their wages plus $434 into FUTA that he/she cannot use. In addition they have to pay for their own health insurance and obviously no vacation/sick pay. Please do not compare employees to business owners. Employees have NO idea. This HR 4213 bill is another attack on the small businesses probably because the politicians cannot control us since most of us are free thinkers and usually not tied to one party. The S Corporation has been around for 50 plus years and has been a blessing to us small one-owner firms. I pay myself a reasonable wage (what I would expect if I work for someone else in my line of work) and then I usually leave a good chunk of money in the company savings account and take a small amount in shareholder distribution. With this new bill even amounts I don't take out will be subject to SECA. I usually save about $3,000 per year in SECA because of the S Corporation. This might not seem like alot to most people but an extra $3000 to my family seems harsh. Why am I being penalized when bigger firms won't be? Why are they picking on the little guy who works hard?????

Also http://biztaxtalk.com/node/1576

The main advantage of forming an S-Corp should be that it allows you to have a formalized corporate structure with shareholders (including employees with bona fide ISOs or restricted stock) without incurring the rather large overhead of maintaining a C-Corp. An S-Corp should simply be the corporate version of an LLC.

It doesn't seem to me that the intent of the S-Corp structure was to allow a small number of people at the top of the company to exempt half their income from taxes that virtually everyone else in the country has to pay.

I don't think you know what you are talking about. I am a CPA and there isn't any larger overhead expenses for one owner C-Corps vs. S-Corps. The main difference is that owners/employees of C-Corps usually just take money out by way of wages only. If they also take dividends they have to pay income tax on the dividends on their personal return, but get no deduction on their corporate income tax return. Thus "double taxation" is the result. S-Corps make it simpler to take distributions and make more sense and are more fair and equitable. Most S-Corps take money out in wages and shareholder distributions. The wages need to be reasonable and the shareholder distributions are a distribution of profit of which you pay income tax on, but there is no double taxation since the income flows through to your personal tax return anyway. I don't know what you mean about small number of people at the top of the company get to exempt half their income from taxes that virtually everyone else in the country has to pay. Our income is not exempt in any way. You might want to know your facts before spouting off stuff you don't know.

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