

Could S Corp Owners Be A Tax Target? - drawkbox
http://www.forbes.com/2010/01/15/irs-gao-medicare-social-security-tax-personal-finance-s-corp.html?boxes=Homepagetoprated
New GAO report, health bill, suggest more might be wrung from them.
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grellas
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.

~~~
DenisM
So if a startup is generating $4k a month, is it assumed for tax purposes that
all of it is paid to the owner with no money left to grow the business? Or is
there a better formula such as MAX(fair salary, 50% of business profits) ?

~~~
grellas
If a tax-pass-through entity wants to retain net _profits_ for business
growth, its several owners still have to pay income tax on those profits in
the year they are earned, regardless of whether they are distributed to the
owners. This is an inherent limitation with this sort of entity, as it does
not easily lend itself to a profitable venture that keeps sucking up cash to
fuel growth. Unfortunately for the individual owners in such an entity, the
net income is imputed to them as earned and the only way they can normally
avoid "phantom income" problems in such situations is to convert to a C corp.

Of course, this applies only with respect to actual profits. If your startup
is generating revenues, and such revenues are spent on growth in ways that
generate deductible business expenses as you go, the only part that is
potentially taxable is the net amount earned after expenses. The revenues in
such a case can be used to grow a business without creating any particular tax
problems for the owners.

------
dennykmiu
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...](http://www.startupforless.org/2008/01/make-money-then-make-meaning-
by-denny-k-miu.html)

~~~
tptacek
You can't just add up the 35% and 9.3% (9.3%! Ouch! Move!), can you? State
taxes are deductable, right?

------
tptacek
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.

~~~
DanielBMarkham
Deciding how to balance expenses in a small corp is not a "huge scam" If it
were so, then what would be the "honest" solution? Having the government tell
S-Corp owners what they should have paid themselves (and therefore what FICA
they owe)? Having a standard FICA bill that "fairly" everyone would owe?

The more you over-complicate the system, the more things are going to happen
that you personally think of as a "scam". Is a realistic solution to
complicate the system further?

Put me on the side of small business owners being able to allocate payroll
expenses as they see fit, and not on the side of arbitrary fees and fines to
make everybody else happier, whether that's for healthcare or FICA.

~~~
tptacek
If we should be able to "allocate payroll expenses the way we see fit", then
I'm going to "allocate" 100% of my taxes back to my bank account. Funny how
that works!

You've missed half the issue. These aren't people taking a $10,000 salary so
they can grow their business. They're taking a $10,000 salary and a $80,000
distribution (self-employment tax is capped) and paying taxes only on the
$10,000.

~~~
DanielBMarkham
Cheap shot.

If you do that, then it's income and you'll pay income tax, as you know.

You can't get something for nothing. S-Corp profits pass through, so they hit
you as income tax, not payroll tax. It's the same situation as a guy who sells
apples suddenly selling a truckload of them -- it's income.

Whining about how people "should" have done this or "should" have done that is
all so much noise. What do you want? A forced payroll system?

~~~
tptacek
I'm now unconvinced that you know what payroll tax is, or how S-Corps work.
One of the reasons you file as an S-Corp is to W2 your income. Owners of
S-Corps pay W2 like everyone else.

This isn't some system where by design we designate S-Corp income as "income"
and thus "exempt from payroll tax" (payroll tax being, for the most part,
FICA). If it was, LLC income --- which is, for owners, _entirely_
distributions --- wouldn't be liable for self-employment tax.

This is a situation where very specifically the S-Corp designation allows
people to create a channel to avoid paying FICA tax that they owe.

If you have $90,000 of income and you're a small business owner, you should be
paying your share whether the income is salary or distribution.

You can call it "whining" and "noise" but since this practice was already an
audit flag I have very little to whine about; my side of the argument already
won. All I'm saying is, "good for them for closing this loophole".

 _[Edit: you clearly do know how S-Corps work, so now I'm wondering why you're
playing semantic games with the word "income".]_

~~~
DanielBMarkham
I've owned an S-Corp for 15 years, I think I would know how one works.

Do you or have you ever ran an S-Corp? You seem to be providing a lot of
opinions. Just wondering what your credentials were.

Owners of S-Corps pay off a W-2 _for that portion of their income paid as
payroll_. The rest of it comes across on a different schedule (1120-S). I've
been doing this for years. I think I know.

All business arrangements have the option of how to handle excess income. Some
entities may pay every penny of it to founders as W-2 income. Some may choose
to pay a bit and hold the rest as savings. Some may create a bonus situation,
LLCs have direct disbursements, etc.

For sole proprietors and S-Corp owners, excess income (income not spent in
payroll or other "legit" expenses) "flows down" to the owner, which has to pay
the rest as income tax.

It's not specific to S-Corps at all. The "scam", as you put it, could be as
simple as the decision to hang on to some cash in the corporate account at the
end of the year instead of paying payroll, or it could be the decision to use
a bonus-as-disbursement system. Either one would be bypassing FICA.

Or you could decide you'd rather not take a payroll for yourself. Perhaps your
income is spotty, you can't afford to pay yourself minimum wage, or perhaps
you can't deal with the overhead required for payrolls. Whatever. It's your
decision.

I'm going to bail out now -- I've played the infinite argument game with you
before. I'm happy to admit fault if I don't understand this -- but I'd be
really, really, really surprised if that was the case.

And congrats on ducking the question I asked about solutions and instead
turning the conversation to my qualifications. Makes it much less a
conversation and much more a debating game.

~~~
tptacek
We file as an S, if you're really wondering.

(You annoy me, but I think your comment is mostly in good faith [I'm pretty
sure you'd rather not come out and make the honest argument, which is that you
think _everyone_ should be able to opt out of Social Security]. I voted your
comment back up to "1".)

~~~
DanielBMarkham
Meta:

No, that is not my position and I do not support that position.

Please do everyone a favor and try to advance the discussion instead of trying
to stick your opponent in some kind of rhetorical box. I asked three questions
and spent all of my bandwidth addressing your attacks on me personally instead
of trying to understand/advance the discussion. The only reason I tried to
talk to you was to find out what your proposed solution was. Instead I'm
dancing around with you trying to justify my right to speak on the matter.
That's really messed up. I don't mind getting trashed, but surely we all have
better things to do here. The purpose of the board is to explain and advance
issues, not score cheap points and "win" debates. It's really getting old.

For the record, here are the questions I had that I never got answered:

 _what would be the "honest" solution?_ _Is a realistic solution to complicate
the system further?_ _What do you want? A forced payroll system?_

Apologies for the meta.

~~~
tptacek
The BEA collects tons of statistics on compensation by geography and vertical.
If you file with a salary far below the norm for your role, location, and
industry, and then take a distribution that brings your compensation above
that norm, you should be audited.

That's roughly the current situation --- except that instead of codifying some
reasonable standard reference for wages, it's up to a court to decide, which
is not what an owner wants. I'm not advocating a Wage Panel.

You're don't appear to be arguing about process. You're arguing against the
very idea of recovering payroll taxes from business owners who have
deliberately filed with artificially low salaries so they can avoid paying
FICA is arbitrary. I'm saying, what seems arbitrary to me is the fact that
simply by organizing their business superficially differently, consultants can
skip out on taxes that normal wage earners have to pay.

------
fexl
" 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.

