S Corp Owner Compensation Strategies

As a business owner, you have four different choice of entity options. Each of these options have different pros and cons and need to be weighed carefully when choosing your entity structure.

Generally, an entity taxed as a sole proprietorship is most common for new businesses just starting out. A sole proprietor is someone who owns an unincorporated business that has just one owner. It is the easiest type of business to establish and dismantle due to a lack of government involvement, making them popular with small business owners and contractors.

A partnership is a formal arrangement by two or more owners to manage and operate a business and share in its profits. An entity taxed as a partnership is best for owning assets.

An entity taxed as an S Corp is best for earning ordinary income from a trade or business.

And an entity taxed as a C Corp is best for income shifting and establishing employee benefit programs.

Sadly, most business owners and their advisors select their choice of tax entity once, then forget it. There’s no “single best entity” for all businesses. In some cases, your best entity option will change over time. In other cases, you’ll want multiple entities to take advantage of multiple tax opportunities.

Now, many businesses are organized as limited liability companies, or LLCs. It’s important to remember that an LLC is a state-level entity classification. However, it’s not a tax classification. A single-member LLC will be disregarded for tax purposes, and thus taxed as a sole proprietorship, unless it elects to be taxed as an S Corp or a C Corp. A multimember LLC will be taxed as a partnership unless it elects to be taxed as an S Corp or a C Corp.

If you’re taxed as a sole proprietor, there’s no separate tax form for your business. You’ll handle everything on your personal return. You’ll report your income and expenses on Schedule C. You’ll pay income tax on your net income and you’ll also pay employment tax on that income. That means 15.3% up to the Social Security wage base (for 2021, that amount is $142,800), plus 2.9% on anything above that amount. You may also pay an Additional Medicare Tax on earned income above a certain limit. On the bright side, proprietorship income qualifies for the qualified business income (QBI) deduction.

Some accountants dismiss the self-employment tax, especially once you exceed that Social Security wage base. But it adds up fast. In our example, we have an owner netting $80,000, and paying $11,304 in SE tax and that does not consider at their regular income tax.

As a general rule, we find that being taxed as a sole proprietor is the most tax efficient structure for a business generating less than $50k in net income per year.

Does it make sense for sole proprietors and partners to pay employment tax on all their business income? Not really, and here’s why.

Owning a business rewards you in two ways. You get paid for the work you do for the business, the same as if you were working for someone else. To that extent, it makes sense that you pay employment tax on that income.

But you also get rewarded for your ownership of the business. And plenty of business income escapes employment tax. Let’s say you own stock in a publicly traded company or any other company that pays a dividend. You’ll pay income tax on it and you may also pay net investment income tax on it if your income exceeds a certain dollar amount. But you won’t pay employment tax on that income because you aren’t personally working to earn it. This is true even if you actually work for that company while you own that stock. You pay employment tax on the portion of your income that represents salary, but not the portion that represents return on your investment.

The S corporation gives you the same benefit. You’ll split your income into two parts. You’ll get a salary, reported on Form W2 just like from any other employer. And you’ll get the net income, just like with a proprietorship or a partnership (Form K-1).

You’ll pay employment tax on your salary, just as if you were working for any other employer. But . . . and here’s where the magic happens . . . you’ll avoid employment tax entirely on the amount that passes through to you as “net income” on Form K1.

S Corp pass-through income qualifies for the qualified business income deduction. It isn’t subject to the 3.8% net investment income tax so long as you materially participate in the business. (IRC Sec. 1411(c)(1)(A)(i).)

Let’s take a quick look at some numbers to see what sort of savings we can create. A minute ago, we looked at a business owner earning $80,000 as a sole proprietor, paying $11,304 in SE tax. If we establish an S Corp (or cause an existing LLC taxed as a sole prop to make an S election) and pay a $40,000 salary, we’ll save $5,184 in employment tax.

This is especially valuable because we’re simply eliminating a tax. We’re not asking you to put $5,184 into a retirement plan, and then deduct it and save 24% or 32% or even 37% but locking it away. We’re not asking you to spend $5,184 on new equipment, and then deduct it. We’re simply avoiding that $5,184 in self-employment tax entirely.

A business who is generating between $50,000 -$250,000 in net income per year should consider making an S election to be taxed as a S Corp.

Now let’s look at the fine print, because you’re probably already wondering: why not pay zero salary, or a ridiculously low amount like a thousand dollars a year?

Well, the rules require you to pay yourself a “reasonable” salary for the work you do as an employee for the corporation. While that’s not always easy to determine, the IRS has laid out nine factors that courts have considered:

Training and experience;

Duties and responsibilities;

Time and effort devoted to the business;

Dividend history;

Payments to nonshareholder employees;

Timing and manner of paying bonuses to key people;

Payment by comparable businesses for similar services;

Compensation agreements; and

The use of a formula to determine compensation.

Using an S Corp to minimize employment tax is a well-established, mainstream planning strategy.

We have tools that help determine what a reasonable salary for services provided would be.

Once a business starts generated more than $250,000 in net income, it is possible that a c corporation might be the right taxation vehicle.

Reasons to be taxed as a C Corporation include:

To establish employee benefit plans
Needs venture capital
Intend to take the company public
The 2017 Tax Cuts & Jobs Act significantly dropped the C Corporation income tax rate from 35% to 21%. This lower corporate tax rate can make the C Corporation particularly attractive for some businesses.

If you have any questions about structuring compensation for S corporations, please feel free to reach out to us.