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I hope I don't get slammed for this, but the tax code is a large pile of stinking dung, and good luck trying to do the right thing. S-Corps work under the gene

I hope I don't get slammed for this, but the tax code is a large pile of stinking dung, and good luck trying to do the right thing. S-Corps work under the general premise that it's just like you, if you were a corporation. So if you don't spend all the income in your business in the year, you owe income tax on what remains. If you have plenty of profits, you write yourself a regular W-2 paycheck. At the end of the year, whatever you don't spend as a legitimate business expense -- even if it's exclusively for business purposes -- is taxed at the same rate as if you had spent the money on whiskey and hookers. Case in point: there is a huge difference between a high-income wage earner who uses S-Corp status for maximum flexibility and the local beautician or mechanic who does the same thing. Lots of independents who are S-Corps have highly volatile income: if you get a client that writes you a check for 50K in January that might be the last income those guys see for that year. So those guys have to make a difficult business decision as to what to do with the money, and the most logical thing to do is to pay business expenses as needed and withdraw the rest as cash disbursements only as a last result. Writing yourself a W-2 paycheck when you're not sure of future income is basically taking away spending money from the business for no logical reason. As I understand it, the system is designed this way on purpose: tough times allow S-Corps to ride on profits and re-tool for the good times. Good times S-Corps work just like "regular" businesses. So for small folks with highly-volatile income, being able to move funds around is the only thing sometimes that keeps them afloat. Unfortunately, there are a lot of guys making 400K a year or more who pay themselves a salary of $20K and take the rest as cash disbursements (thereby avoiding paying themselves as W-2 employees mostly altogether) The reason the tax code is such a mess is that folks get mad at one bunch or another that they think are not acting fairly, so they punish them -- usually punishing many more than the original target. Or politicians want extra votes, so they make an exception for certain people -- usually providing exceptions to hidden interests and creating perverse incentives. 60 years of this and you have a complete disaster. So yes, by all means make folks pay their share, just be aware that the guy you read about in the paper isn't necessarily the average guy. It's not an "income trick" if it helps the economy grow.

matwood 16y ago
Well in this case it really is an income trick. I have friends who do S-corps for this reason and the main thing they stress over is paying themselves a fair market salary. The guy in the article was paying himself barely 1/2 what a new grad would make so it's clear that he was well below fair market. If he had just paid himself fair market he would still have come out ahead and not had to deal with the IRS.
- tptacek 16y ago
  I think there's a lot of smoke being blown about the "fair market salary" thing, as if the IRS was capriciously planning the US economy during audits. It seems to me --- and I'm prepared to be wrong here --- that the deal is simple: look at your quarterly estimated payments, add up all your income, and if it looks like you're getting a significant break on FICA because of the way you've structured your income, fix it: there's no free lunch.
  - wuputah 16y ago
    I disagree unless the payment you are making to yourself as distributions is fair compensation for services provided to the company. A company's purpose is to make a profit, and if you are distributing profit to yourself, then there is no reason to pay FICA on that income. The "fair market salary" is important because if you are forced to pay yourself arbitrarily more (like you suggested), it would be in the best interest of the person to instead hire someone to do his job for him (at fair market salary) and simply collect the profits. (In fact, this could be the long term goal: hire someone to manage the business and retire on the profits!) If you'd like to know why it's "fair" for people to be allowed to pay income tax and not FICA tax on profit, then you need to look at the C corporation code. Under this system, the corporation pays a corporate income tax, and then can pay profits to its shareholders as dividends, which are then also subject to a second tax. You'll note that there is no payroll tax in this system. The purpose of an S-corporation is to avoid this "double taxation" for very small companies and instead use the personal income tax code, which may be (but is not necessarily) cheaper for the shareholder. This is not a loophole: it is by design. It is also worth noting that just because the taxes are paid through the personal income tax code, that doesn't mean that person received that profit as a cash distribution. That money may very well be put to a different purpose, e.g. investing in the business in some way which is not yet tax deductible (like a large capital purchase), in the bank as float, or invested in some way. In the case mentioned in the article, I certainly agree the owner was not paying himself enough by W-2 for his services, particularly if he was the sole employee and otherwise received that income as a cash distribution. He is obviously an experienced CPA who would be paid much more on the open market, and as a CPA, he should have known better.
tptacek 16y ago
Respectfully --- I like you and your comments, even though our politics couldn't be more different --- you should get slammed for this analysis. You're muddying the waters and you know it. The prevailing market wages for beauticians and mechanics are so low that that benefit of evading FICA is marginal. S-Corp owners are rarely audited period, but here you ask us to consider that enforcement of the tax code might focus on them. Of course it doesn't. Moreover, you've conjured up this issue of income flexibility, the idea that feast-or-famine will cause people to need irregular salaries. But that's not an issue at all. You can pay yourself an irregular salary. Just make sure your quarterly estimated tax payments treat most of it as payroll. The only time this S-Corp rule becomes an issue is when you explicitly invoke it to avoid FICA. Don't do that. It is not difficult to avoid the problem this article talks about: unless your salary approaches the FICA cap (last year it was just shy of 100k), don't pay yourself a significant fraction of your total income in distros. What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole.
- tbrownaw 16y ago
  > What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole. So if everyone is supposed to pretend it doesn't exist, why does it exist?
  - tptacek 16y ago
    The tax structure S-Corp owners are taking advantage of is the one that governs investment income. These people are deliberately reclassifying their compensation as return on the investment of having started a business.
    - abalashov 16y ago
      Thanks, that clears it up. I was reading the article wondering since when these people don't have to pay SEP taxes.

matwood 16y ago

Well in this case it really is an income trick. I have friends who do S-corps for this reason and the main thing they stress over is paying themselves a fair market salary. The guy in the article was paying himself barely 1/2 what a new grad would make so it's clear that he was well below fair market. If he had just paid himself fair market he would still have come out ahead and not had to deal with the IRS.

tptacek 16y ago
I think there's a lot of smoke being blown about the "fair market salary" thing, as if the IRS was capriciously planning the US economy during audits. It seems to me --- and I'm prepared to be wrong here --- that the deal is simple: look at your quarterly estimated payments, add up all your income, and if it looks like you're getting a significant break on FICA because of the way you've structured your income, fix it: there's no free lunch.
- wuputah 16y ago
  I disagree unless the payment you are making to yourself as distributions is fair compensation for services provided to the company. A company's purpose is to make a profit, and if you are distributing profit to yourself, then there is no reason to pay FICA on that income. The "fair market salary" is important because if you are forced to pay yourself arbitrarily more (like you suggested), it would be in the best interest of the person to instead hire someone to do his job for him (at fair market salary) and simply collect the profits. (In fact, this could be the long term goal: hire someone to manage the business and retire on the profits!) If you'd like to know why it's "fair" for people to be allowed to pay income tax and not FICA tax on profit, then you need to look at the C corporation code. Under this system, the corporation pays a corporate income tax, and then can pay profits to its shareholders as dividends, which are then also subject to a second tax. You'll note that there is no payroll tax in this system. The purpose of an S-corporation is to avoid this "double taxation" for very small companies and instead use the personal income tax code, which may be (but is not necessarily) cheaper for the shareholder. This is not a loophole: it is by design. It is also worth noting that just because the taxes are paid through the personal income tax code, that doesn't mean that person received that profit as a cash distribution. That money may very well be put to a different purpose, e.g. investing in the business in some way which is not yet tax deductible (like a large capital purchase), in the bank as float, or invested in some way. In the case mentioned in the article, I certainly agree the owner was not paying himself enough by W-2 for his services, particularly if he was the sole employee and otherwise received that income as a cash distribution. He is obviously an experienced CPA who would be paid much more on the open market, and as a CPA, he should have known better.

tptacek 16y ago

Respectfully --- I like you and your comments, even though our politics couldn't be more different --- you should get slammed for this analysis. You're muddying the waters and you know it. The prevailing market wages for beauticians and mechanics are so low that that benefit of evading FICA is marginal. S-Corp owners are rarely audited period, but here you ask us to consider that enforcement of the tax code might focus on them. Of course it doesn't. Moreover, you've conjured up this issue of income flexibility, the idea that feast-or-famine will cause people to need irregular salaries. But that's not an issue at all. You can pay yourself an irregular salary. Just make sure your quarterly estimated tax payments treat most of it as payroll. The only time this S-Corp rule becomes an issue is when you explicitly invoke it to avoid FICA. Don't do that. It is not difficult to avoid the problem this article talks about: unless your salary approaches the FICA cap (last year it was just shy of 100k), don't pay yourself a significant fraction of your total income in distros. What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole.

tbrownaw 16y ago
> What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole. So if everyone is supposed to pretend it doesn't exist, why does it exist?
- tptacek 16y ago
  The tax structure S-Corp owners are taking advantage of is the one that governs investment income. These people are deliberately reclassifying their compensation as return on the investment of having started a business.
  - abalashov 16y ago
    Thanks, that clears it up. I was reading the article wondering since when these people don't have to pay SEP taxes.