*** This is legacy information. Please see our completely revamped and really cool book on this ***
Avoiding or Reducing Self-Employment (SE) Tax
We encourage you to keep reading this KB Article for the quick facts and considerations. Additional in-depth articles are linked below, but you can also read our insomnia-relief version as a PDF with the following link-
This KB article was the inspiration for our book which is available in paperback from Amazon, as a PDF and as an eBook for Kindle, Apple, Barnes and Noble, among others. You can cruise through these KB articles, or visit our webpage which provides more information at-
If you own a business as a garden variety single-member LLC (one owner or shareholder), your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. The same is true for a business that has not formed a corporation such as a sole proprietor and partnerships. So, you could easily pay an average of 30% (15.3% in SE taxes + 15% in income taxes) on all your net business income in Federal taxes. Wow!
However, if you own an LLC and have elected to be treated as an S-Corp (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. What’s the big deal? you say. Before we get into that, let’s look at some quick numbers (based on a required yet reasonable salary of 50% of total income)-
We’ll chat about why the savings drops off after $100,000. For now, let’s look at why there are savings at all. The S-Corp election of your LLC changes how the LLC reports income to the IRS. An S-Corp prepares and files a Form 1120S which is a corporate tax return. That in turn generates a K-1 for each shareholder. Remember, shareholder and owner are synonymous terms.
A K-1 is a statement that each shareholder receives, and it is similar to a W-2 since it reports the income that each shareholder is responsible for from a taxation perspective. There are two types of K-1s for the purposes of our discussions- one is generated from a Form 1065 and the other is generated from a Form 1120S. A Form 1065 is also called a partnership tax return, and typically your K-1 will be subjected to self-employment taxes.
However, a K-1 generated from a Form 1120S (LLC or C-Corp, either with the S-Corp election) is reported on the shareholder’s personal tax return on Schedule E. Schedule E is the form used for rental properties, royalties and other investment income including business income from an S-Corp.
You’ll hear terms such as pass-through entity or disregarded entity- these mean essentially the same thing from a taxation point of view since the S-Corp is not paying taxes. Rather it is passing the liability through to the shareholders.
The Money Trail for S-Corp Elections
And when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social Security (FICA) and Medicare taxes. Same thing.
Let’s look at another visual in terms of how the money travels-
S-Corp Hard Money Facts, Net Savings
At $100,000 you could still net out a $3,400 savings. Not bad.
The savings between an LLC and an S-Corp LLC drops off at some point because what is paid as a reasonable salary is equal to or greater than the Social Security cap. For example, if your LLC earns $250,000 your Social Security contribution limit will have been reached at $113,700 for 2013. And if your LLC becomes an S-Corp, your reasonable salary at 50% (or $125,000) will also meet the limit. There are some Medicare issues to consider as well.
The Organization of an S-Corp
So while we might talk about your “S-Corp”, we are truly talking about your partnership, LLC or C-Corp being treated as an S-Corp for taxation. And while there are partnerships and C-Corps out there who elect to be treated as an S-Corp, this article will focus on the S-Corp LLC. However, the information is valid for each entity type.
Downsides to S-Corp Election
Please read the expanded KB Article on the disadvantages or downsides to the S-Corp election. Here is a summary-
Operational Hassles of an S-Corp
The two other requirements are paying a reasonable salary through payroll and preparing a corporate tax return. And if you use the Watson CPA Group (and you should), then this hassle is ours not yours. Well, not entirely true- we are attached at the hip if we prepare your tax returns, but the hassle is mostly ours.
Reasonable Salary Determination
There are two types of discounts. First, if we perform the bookkeeping then the corporate tax return is fixed at $375. Second, if we perform all three services (tax return, bookkeeping and payroll) an additional 10% discount is provided.
For example, you need quarterly bookkeeping, quarterly payroll and a corporate tax return. The range would be $1,850 to $2,650 before the 10% discount. Or $1,665 to $2,385 after the discount. This is per year. Most one or two-person companies with a single checking account and a single credit card can expect to spend right around $1,800 per year or $150 per month.
Just an S-Corp tax return and payroll (no bookkeeping) will be about $1,200 per year.
These general fees will cover most situations. However, depending on the number of transactions, accounts and employees, these fees might have to be adjusted to reflect additional complexities.
Unless you have other employees, we suggest shareholders to pay a reasonable salary to themselves quarterly, for a total of four pay checks per year. This will coincide with your estimated tax payments on your K-1 income. Remember, you can write checks directly to yourself as often as necessary throughout the quarter. These are considered shareholder distributions.
Estimated Tax Payments
Corporate Tax Return
Determining the Payroll Amount
The big question becomes what to pay yourself as a wage. The amount of wages can change quarterly depending on your quarterly profit levels. While your particular situation might warrant further discussion, a good place to start is half of your net profits being paid as wages. If your income is routine or consistent, then you can also elect to pay a strict annual wage on a quarterly basis.
There are two methods of paying wages- one is forward looking and one is backward looking. The forward looking method is to establish the quarterly wage, and write that check separately to the shareholder(s) with the associated taxes withheld. The backward looking method is to continue to pull money out of the business as needed (daily, weekly, monthly, etc.) for your living expenses. Then, those monies are reclassified as either wages or shareholder distributions, and the taxes associated with the reclassified wages are processed, filed and paid.
If you have other W-2 income from another job or employer, more discussion is required to minimize tax consequences. Since each job doesn’t know about the other, taxes withheld will be based on just one income and not two. We strongly suggest keeping W-4 exemptions very low or zero on the lower income until some history is built and you can manage expectations.
The $0 Paycheck
In other words, it is unnecessary to stockpile $10,000 in your business account just to run payroll for half of Q1’s net profits. You would only need to keep enough cash available to cover the taxes, and we can plan for that payment about 30 days out from the due date. Make sense?
Pull Money Out, Accountable Plan
We encourage S-Corps to create an Accountable Plan which allows shareholders (or owners of garden variety LLCs) to turn in expense reports for home office use, mileage, cell phone, internet, meals and travel. It is easy to do, and is a great way to pull money out of the business, and actually reduces the amount of taxes paid. A win-win scenario.
If you reimburse yourself without an Accountable Plan, that money is considered taxable income. You in turn have to deduct those expenses as unreimbursed employee business expenses subject to itemized deductions and income thresholds.
For more information on Accountable Plans please read our tax article on LLCs at-
For a sample Accountable Plan form that you can use-
Retirement Planning within an S-Corp
Health Care Expenses, Premiums, HRAs, HSAs
Health Insurance Premiums
On your personal tax return, you will get a deduction for health insurance premiums paid. This directly reduces your adjusted gross income, and is not a Schedule A itemized deduction (which is good). If this procedure is not followed, the premiums can only be deducted on Schedule A subject to the 7.5% or 10.0% income thresholds for medical expenses (which is not good).
Health Reimbursement Arrangement (HRA), Health Savings Account (HSA)
Even if you have an HSA at your other job, you can use the HRA to reimburse your medical expenses and let the HSA grow. When you need a new hip at age 70, you’ll be drawing money from somewhere- either your 401k or your HSA. So in some regards, your HSA becomes a retirement vehicle.
Child’s College Education with an S-Corp
The Age 21 rule stems from attribution rules whereby a child under the age of 21 is deemed to own the same percentage as their parents. So, if you own 100% and your child is 20, your child is considered to be a 100% owner for this benefit (and many others), which obviously exceeds the 5% rule.
Electing S-Corp Filing Status, Retroactive for 2013
There is also a strong possibility that we can make the S-Corp election retroactive for 2013. As mentioned earlier, one of the pillars of S-Corps is to pay a salary to the shareholders. So, what happens if it’s 2014 and you didn’t run any payroll? There are three options (in descending order of elegance)- reclassify distributions as wages, issue a 1099 to yourself and roll the dice. Read our expanded KB Article on this particular topic for more information.
Other Tricks of the Trade with S-Corps
Car Ownership, Paying Rent, Home Office Deduction
For a sample Accountable Plan form that you can use-
Audit Rates and Risks with an S-Corp
Therefore, S-Corps have become super popular because of the low audit risk and more importantly the savings of self-employment taxes. The IRS is catching on however, and is targeting S-Corps where little to no salary is being paid to the shareholders. And this is easy to do. The IRS connects the dots by back-tracking K-1s to your company’s EIN to your company’s list of W-2s to the W-2’s Social Security numbers back to your K-1. The IRS probably has an app for that.
If your K-1 does not have a corresponding W-2, or if your W-2 income is low compared to your K-1 income you are creeping up on the “let’s call this guy” list. In other words, your audit risk is increasing.
Recap of S-Corps
Attention! Sales pitch coming- S-Corps are easy, they typically make sense, and they will improve your financial position in life. Contact us to get started. Did that sound too cheesy?
Please call or email us anytime with your questions and concerns, or to schedule a consultation. Thank you in advance, and we look forward to working with you!