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This isn't a deduction. A deduction is when you offset taxable income with deductible expenses. I also resent the fact that anyone would refer to these returns

This isn't a deduction. A deduction is when you offset taxable income with deductible expenses. I also resent the fact that anyone would refer to these returns as "shady". My accountant tells me that the reasonable salary requirement is typically interpreted as anywhere between a 60/40 and 80/20 ratio of salary to distribution income. "Abuse" in this case is when someone takes the vast majority of their income as a distribution in order to avoid paying SS and FICA tax. The reason S-corps get a break here is because of the unique niche they occupy. A well capitalized business is a good business. The intended operation of an S-corp, and what is currently incentivized through the tax structures in place, is this: an S-corp owner takes a "reasonable salary" (as defined above), but enjoys pass-through tax status on the remainder of the income. They pay federal withholding on this amount, but benefit from a lack of SS or FICA taxes. The primary source of capitalization in a small business is the primary shareholder. That is, in tough times, the owner will have to contribute money back in to the business in order to sustain it. This is because the corporation itself cannot hold any assets. Without this benefit, there's really no point in filing an S-corp election. You might as well just file as a C-corp. The tax differences are negligible.

tptacek 16y ago
You are missing the part where only the small number of people who have enough shares in the S-Corp to soak up 40% of their income get to take advantage of this loophole. The rank and file employees of an S-Corp, even if they're getting "first-employee" levels of equity, don't get to play this game. You're also dancing around the fact that the IRS can already determine by fiat what "reasonable" salary is. I'm not an accountant. We're an LLC filing as an S-Corp. We have professional accountants. We have not been advised of any "60/40" rule. What I have been advised of is that tax courts interpret any compensation an employee of an S-Corp gets for services rendered as a wage, and wages are subject to FICA. My hunch --- and that's all it is --- is that this 60/40 business is less about what the tax courts interpret the tax code as, and more about what will prevent your returns from getting caught in the IRS dragnet. That doesn't mean that taking 40% of your wages as distributions and skipping FICA on them is actually aboveboard. The big differences between S and C corps is that C corps pay federal corporate tax and C corps have preferred stock. I also have to add, at severe risk of getting smacked down by 'grellas, that I think your argument about "the reasons why S-Corporations get this break" is unsupported by evidence. In fact, when I read the "Opinion" sections of court cases involving decisions about distros versus wages (every one of which I found finds for Revenue and not the company owner), I see things like: Dr. Sadanaga performed substantial services on behalf of petitioner. The characterization of the payment to Dr. Sadanaga as a distribution of petitioner's net income is but a subterfuge for reality; the payment constituted remuneration for services performed by Dr. Sadanaga on behalf of petitioner. An employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation's net income, rather than wages. Regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments represent remuneration for services rendered. Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990); Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (?th Cir. 1990). The question doesn't appear to be "does your company deserve a break". Rather, it's pretty straightforwardly: "is this money you're earning as compensation for your work, or is this money you're earning as compensation for the downside risk of an investment you hold". I'm sorry that you feel like I'm calling you shady. I don't even know you. I don't think you are shady. But this business of allowing S-Corp owners to exempt themselves from half their FICA obligation just because of a quirk in how they file taxes is, as I see it, shady.

tptacek 16y ago

You are missing the part where only the small number of people who have enough shares in the S-Corp to soak up 40% of their income get to take advantage of this loophole. The rank and file employees of an S-Corp, even if they're getting "first-employee" levels of equity, don't get to play this game. You're also dancing around the fact that the IRS can already determine by fiat what "reasonable" salary is. I'm not an accountant. We're an LLC filing as an S-Corp. We have professional accountants. We have not been advised of any "60/40" rule. What I have been advised of is that tax courts interpret any compensation an employee of an S-Corp gets for services rendered as a wage, and wages are subject to FICA. My hunch --- and that's all it is --- is that this 60/40 business is less about what the tax courts interpret the tax code as, and more about what will prevent your returns from getting caught in the IRS dragnet. That doesn't mean that taking 40% of your wages as distributions and skipping FICA on them is actually aboveboard. The big differences between S and C corps is that C corps pay federal corporate tax and C corps have preferred stock. I also have to add, at severe risk of getting smacked down by 'grellas, that I think your argument about "the reasons why S-Corporations get this break" is unsupported by evidence. In fact, when I read the "Opinion" sections of court cases involving decisions about distros versus wages (every one of which I found finds for Revenue and not the company owner), I see things like: Dr. Sadanaga performed substantial services on behalf of petitioner. The characterization of the payment to Dr. Sadanaga as a distribution of petitioner's net income is but a subterfuge for reality; the payment constituted remuneration for services performed by Dr. Sadanaga on behalf of petitioner. An employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation's net income, rather than wages. Regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments represent remuneration for services rendered. Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990); Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (?th Cir. 1990). The question doesn't appear to be "does your company deserve a break". Rather, it's pretty straightforwardly: "is this money you're earning as compensation for your work, or is this money you're earning as compensation for the downside risk of an investment you hold". I'm sorry that you feel like I'm calling you shady. I don't even know you. I don't think you are shady. But this business of allowing S-Corp owners to exempt themselves from half their FICA obligation just because of a quirk in how they file taxes is, as I see it, shady.