As most business owners are aware, income that you generate in your business that you are conducting as a sole proprietor (or through a wholly-owned limited liability company (LLC)) is subject to both income tax and self-employment tax. The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for social security up to the social security maximum ($106,800 for 2010) and a 2.9% rate for medicare, without any maximum. Similarly, if you conduct your business as a partnership in which you are a general partner, in addition to income tax you would be subject to the self-employment tax on your distributive share of the partnership's income. However, if you conduct your business as an S corporation you will be subject to income tax, but not self-employment tax, on your share of the S corporation's income.
An S corporation is not subject to tax at the corporate level. Instead, the corporation's items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you can avoid self-employment income tax.
There is a problem, however, in that IRS requires that the S corporation pay you reasonable compensation for your services to the S corporation. The compensation is wages which is subject to employment tax (split evenly between the corporation and the employee) which is equivalent to the self-employment tax. If the S corporation does not pay you reasonable compensation for your services, IRS may treat a portion of the S corporation's distributions to you as wages and will impose social security taxes on the deemed wages. There is no simple formula regarding what is reasonable compensation. Presumably, reasonable compensation would be the amount that unrelated employers would pay for comparable services under like circumstances. There are many factors that would be taken into account in making this determination.
Please feel free to contact us if you would like to discuss the practical aspects of conducting your business through an S corporation and how much the S corporation would have to pay you as compensation. I look forward to hearing from you.
