S Corps are limited liability corporations. Lots of LLCs turn themselves into S Corps, because (a) there's an old sketchy tax dodge about self-employment/FICA tax you can do as an S, and (b) it's easier to grant employees equity in an S than an LLC.
It's not as sketchy as it used to be, due to some rules changes in the last few years.
As a one-person S-Corp, you run payroll and you are your own employee. You can set your salary, and you can also pay yourself in distributions. Salary is subject to FICA, distributions are not. Both are subject to income tax.
When you pay yourself salary, your "personal" side pays its half of the FICA, and your "business" side pays the other. This is the same way a regular employer/employee relationship works (and why it "feels" like you are paying double FICA when you're self-employed; it's because you are both the employee and the employer).
It used to be that you could severely limit your salary, and pay yourself the bulk of your income through distributions, and lower your tax bill by having lower FICA costs.
These days, it is your responsibility to pay yourself a "reasonable salary", as in something you could reasonably defend during an audit. Once you have paid yourself a reasonable salary (which is subject to FICA), you can give yourself more money (revenue permitting :) ) in distributions.
Also, if your self-employment is part-time, you can pro-rate your salary to reflect that part-time employment.
It's also worth noting that as your business gets successful and long-term, you may want to increase your salary and pay into FICA so you can get a better social security payment when you retire. But still, if you analyze it in a spreadsheet, you'll see that social security, as an annuity, is a "bad deal" when you're paying both sides. (It's a very good deal as a W-2 employee with someone else paying the employer half, though.)
> (It's a very good deal as a W-2 employee with someone else paying the employer half, though.)
I agree with everything you say here, except this last sentence.
It would be true if the money were coming from a truly external source, but from an economic perspective, this is no different from a "normal" sales or income tax. As a result, it doesn't matter who is nominally paying it - the "real" payer (the incidence of the tax) depends on the relative elasticity of the supply and demand.
As it turns out, empirically, about 95% of the incidence of FICA (if I remember correctly) falls on the employee. In other words, it doesn't matter if the employer is nominally paying for half - they factored that in already when deciding how much to offer the employee when they hired him or her.
For many people reading this thread, Social Security is a bad deal no matter how you look at it - for many people reading this, it will be literally impossible to earn as much back from Social Security as they have paid in (assuming a vaguely realistic life expectancy).
(This is not a political statement, by the way - whether or not one believes that Social Security is good or bad depends on how much value one places on transferring a bit of wealth in order to guarantee a minimum income for the elderly. I just wanted to point out a part of the Social Security calculus that is easy to overlook.)
As I understand it, reasonable though your claimed salary might be, if you're making money on the difference between distros and salary (which stops being an issue at around the 100k point), you're filing returns with a big red audit flag on them. The tax savings probably aren't worth the heartache for a lot of people.
Not for nothing, but as an entrepreneur who has been in exactly the situation contemplated by this scheme: avoiding taxes by structuring your income as a "distribution" rather than salary is shady. I think it's unethical. People that don't happen to run S Corps don't get to do it. I'm prepared to lose the argument, so let me concede it in advance and avoid polluting the thread.
Well, as someone that quite likes the idea of things like social security and universal health care, I wholeheartedly agree that it's wrong to falsely deflate one's salary in an effort to avoid paying into FICA. But I guess it has never been argued to me that beyond the reasonable salary, it should be one's responsibility to pay excess profits as salary rather than distributions. I can't really find a good reason to hang my hat on. I think the entire reason S Corps exist are to encourage small businesses since we otherwise take on a lot of risk, no? Too bad that threads get polluted right when discussions get interesting. :-)
I agree with the analysis above, with one addition: a big reason to pay yourself more at any owners only profitable small business is to max out a contribution to a 'individual 401k', sep-ira, or similar. The rules vary, but if your 'salary' is in the $250k ballpark, you can contribute up to $51k in additional money to a tax deferred retirement plan. Just like a 401k, it grows tax free.
Most SS taxes are capped just above $100k, and if you own a tech company it's pretty hard to argue you salary should be below that, so the SS angle is limited. But tax free compounding on $51k/yr is a significant benefit.
Disclaimer: I am not an accountant, nor is my business set up as an S corp.
The way it works is this: you form an S corp, and as the owner you pay yourself dividends rather than straight income. That way you aren't taxed at normal income tax rates but instead at the capital gains rate. At the same time, because you are now an employee of the S corp you personally only pay half the social security tax, rather than the whole bit as you would as the owner of the LLC paying both the employer and employee portions (of course the corporation is still obligated to pay the employer contribution).
Accountants are of different minds on this, depending on their own taste for risk. The important question in an audit is being able to defend that the business is more than just you, IE: the income is legitimate dividends from the success of the business, and not just regular employment income masquerading as dividends. Again, consult an accountant - they really are worth the cost.
I think this is incorrect in two ways - you do still have to pay yourself salary, and dividends are taxed at normal income rates (due to pass-through) rather than capital gains rates. It's unfortunate that they are called dividends, because stock dividends are taxed at capital gains rates.
Curt - perhaps I could have written out explicitly "you still have to pay yourself a salary" but that was what I was trying to infer with my comment of "...because you are now an employee of the S corp..." I see you are also in Oregon, you might have better local advice for the parent poster. At a minimum, since you are both local to Portland you should meet up for a beer. ;-)
I think you're using incorrect terminology here. Dividends comprise capital that is distributed from a C Corp, and have a special taxation structure that is separate from ordinary income.
Josh - I see you are based in Portland (hello "neighbor!" - I'm about a 4 hour drive east from you). You'd probably be just as well off moving over the river to shed the Oregon state income tax (sorry Oregon, I love you but...). Setting up an LLC in either Oregon or Washington is trivial. Setting up an S or C corp in Washington (I've never done it in OR) is also really easy, but does involve more paperwork. Especially in the early days of a business, there are so many advantages to setting up an LLC that I'd be surprised if an accountant advised otherwise. Have a deep-pocketed investor ready to go? That's the only case where I can imagine that setting up a C corp from the beginning makes sense.
Respectfully, please don't delete posts. Edit in a warning at the top that you were wrong and realize it or something. People reading these conversations later now have no context, which is frustrating.
