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I have operated as a consultant under my LLC classified as an S-Corp, of which I am the sole owner and sole employee. Over the past many years, I have had, say, a business income of $60,000, which is generally spent on expenses including salary.

I had a good year this year, and the business income is approximately, say, $300,000. I have never yet taken a distribution before, but I thought I would this year. Granted, I would pay myself an appropriate salary (say, $60,000) and take, say $200k as a distribution. I thought I would be able to reap significant tax savings by avoiding FICA tax on the $200k, but as I calculate things, in the end my overall personal tax liability is the same!

Am I on crack, or do the perceived tax savings via S-Corp distributions really not matter at a certain level of business income?

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  • As you can see from the disagreements in the answers, this is something you should probably take up with a licensed professional well versed in the recent case law on the issue of S-Corp owners' compensation. This is not a question on which you can get a reliable answer from amateurs.
    – littleadv
    Sep 11, 2013 at 2:45
  • This question appears to be off-topic because it requires a legal advice.
    – littleadv
    Sep 11, 2013 at 16:44

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Am I on crack, or do the perceived tax savings via S-Corp distributions really not matter at a certain level of business income?

You're not on crack. Generally, if all the income is generated by your own personal services - this is the outcome.

The benefit of S-Corp is when you have employees who generate your income, and you distribute to yourself profits that come out of other's personal services. In this case your distributions are exempt from FICA since it is not in fact a self-employment income. You'd still have to pay yourself a reasonable salary for your position (as a manager/officer), but it wouldn't have to cover all of the available profits.

So if the IRS takes a position against you it would be that your salary should be to include the whole profits, since it is the compensation to you for the personal services that produced the income to the corporation (you). In many cases they might agree that a salary at the SS maximum limit would be reasonable - but that's only a speculation of mine. In that case you might gain some portion of the medicare tax (with the recent law changes at the levels you're talking about you'll pay some medicare anyway).

There are a lot of accountants who take more aggressive position saying that not all of the distributions are liable for SE taxes, even if you're the sole employee of the corporation. These cases often end up in the Tax Court, and whatever the outcome, your legal fees become higher than the FICA savings.

What is probably missing in your picture is the SS limit of (currently $112K) above which you don't pay social security tax, so whether you get it as a salary or as a distribution - that limit is the same. That is why you don't see a significant difference.

I know there are a lot of accountants who'd disagree, but I would argue that for a sole employee of your company, S-Corp doesn't provide significant benefits over the disregarded LLC taxation, but has some additional overhead that adds to your expenses.

Here's a link to a lawyer's blog where he suggests (and says many accountants follow) 60/40 division between salary and distributions. I.e.: his take, similarly to mine, is that most of the earnings have to be treated as salary. In your case, when the total is about 300K - you indeed will not get any FICA savings with such a division other than some of the medicare.

Unusually low wages when compared to distributions can draw unwanted IRS scrutiny and an audit. An unfavorable audit will likely result in some portion of the distributions being reclassified as earned income for federal income tax purposes, which results in a deficiency assessment (i.e., a tax bill), interest on those unpaid taxes, and IRS penalties.

The article also talks about the Watson case (one of the Tax Court cases I referred to), which can be used as the guidelines for determining the "reasonable" compensation.

Talk to your tax adviser.

I'm neither a tax adviser nor a tax professional. For a tax advice contact a CPA/EA licensed in your state. This is not a tax advice, just my personal opinion.

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    I deleted my comment in which I thought this was "incorrect". Better to have said I disagree. I believe taking a smaller salary is a very common practice. So common that my payroll service uses it as a selling point to form an S-Corp and start doing payroll. (BTW the negative vote is not from me).
    – Phil Sandler
    Sep 11, 2013 at 1:12
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    As I said - there are accountants that disagree. However there have been some recent Tax Court rulings which are consistent with my, more conservative, approach. I'd say - better be safe than sorry. Taking a smaller salary, while a common practice, is a shady practice and is on border of being tax evasion. There are a lot of people promote a lot of things. Selling point of S-Corp is the benefit of SE exempt income when you have employees, not when owners are the only one who produce income. It is to avoid double taxation, not FICA.
    – littleadv
    Sep 11, 2013 at 1:24
  • "I would argue that for a sole employee of your company, S-Corp doesn't provide significant benefits over the disregarded LLC taxation, but has some additional overhead that adds to your expenses." I would love to hear more about your reasoning behind this... because I am witnessing the truth.
    – ybakos
    Sep 11, 2013 at 20:30
  • @ybakos the reasoning is that since all the S-Corp earned income is income earned by you personally, it will be hard for you to claim that some of it is exempt from FICA. S-Corp is useful mainly for those who want the limited liability and cannot work under LLC (lawyers, doctors, accountants, etc), or those who want corporate structure and pass-through taxation (avoiding double taxation).
    – littleadv
    Sep 11, 2013 at 20:48
  • @ybakos the overhead being, of course, the costs of additional bureaucracy (corporate tax return, filings with the State, maintaining records, etc), additional taxes (state corp taxes, payroll taxes that are not part of FICA), and additional operational costs (payroll, mainly).
    – littleadv
    Sep 11, 2013 at 20:50
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Payroll taxes are only paid on salary, so you will be paying SS Tax and Medicare only on the $60,000 you pay yourself. You will still pay income tax on the distribution, of course, but the payroll tax savings seem significant (~$13K according to the calculator below).

While tinkering with a new web technology some time ago, I created this JsFiddle application. I can't swear to its correctness, but I'm pretty sure it's solid (use the UI in the bottom right quadrant of the screen):

http://jsfiddle.net/psandler/NKAZd/

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    Phil, this is illegal. -1. You cannot decide arbitrary what your salary is. If your services cost $300K, you cannot claim that $60K is a reasonable salary. K-1 income from S-Corp is a SE income by default, and while you can get away with small things, several hundreds of thousands are likely to trigger an audit.
    – littleadv
    Sep 11, 2013 at 1:24
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    Where did I say that $60K was a reasonable salary on $300K in revenue? Where did I recommend arbitrarily deciding what your salary should be? Please re-read the question and re-read my answer--I have given a direct answer to his/her question, and did not attempt to give him tax advice.
    – Phil Sandler
    Sep 11, 2013 at 12:35
  • The 60K he mentioned was for prior years what for this year is 300K. The assumption that the salary for income of 60K is the same as for income of 300K is flawed. Clearly more/different work was done.
    – littleadv
    Sep 11, 2013 at 16:43
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    I realize this is a month old, but I didn't see your additional comments until now. I would again encourage you to read the question and my answer. The question is the tax benefit of taking distributions instead of salary, not the legal or moral implications thereof.
    – Phil Sandler
    Oct 21, 2013 at 1:16
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    That might be the worst analogy in the history of mankind. He posed a factual question, I responded with a factual answer. I'm going to officially give up on this discussion now, probably a month late.
    – Phil Sandler
    Oct 21, 2013 at 12:51

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