Sub-Chapter S Corporations and Social Security

Using the Subchapter S corporate form for a business offers many benefits. Sub S corporations pay no income tax, they provide the ability to have multiple shareholders, they are relatively easy to establish and the income (or loss) flows through to the shareholders' individual income tax returns.

Another potential benefit of a Sub S is the nature of its income relative to Social Security taxation. The income of a Sub S is reported to shareholders on Schedule K-1 and is taxed as ordinary income to the shareholder. However, unlike income from a partnership or sole proprietorship, this Sub S income is not considered to be self-employment income under the tax laws and therefore is not subject to Social Security or Medicare taxes.

For a Sub S shareholder, this can be significant. For self-employment or partnership income, the Social Security tax is 12.40% on income up to $106,800 and the Medicare tax is 2.90% on all income. For a Sub S shareholder that takes $100,000 of "income" as Sub S income (on Schedule K-1) instead of wages (on Form W-2), the potential savings can be $15,300.

As with all tax issues, the rules can be complex and you may want to consult with your tax advisor to learn how this concept may apply to your situation.

The Opportunity
In most cases, shareholders of a Sub S corporation are also the managers of the company. They may have the ability to control how much of the profits of the company they take as wages (subject to payroll taxes) versus taking money out as a loan, payout of profits or return of capital (not subject to Social Security or Medicare taxes). Earnings taken as wages reduce the income of the company, so in both cases, their income subject to income taxes is the same. However if the profits are not distributed as wages, the savings in payroll taxes can be significant.

The Pitfalls
Social Security is an important part of most individuals' retirement income. The amount of Social Security benefits you will receive is dependent on the amount of your wages and what you have paid in during your working years. If you pay in less, you may receive less.

The other negative to using this concept is how it applies to the ability to make tax-deductible contributions to various types of retirement plans. Most qualified retirement plans (SEP-IRA, Keogh, and 401k plans), have annual contribution limits based on a percentage of the compensation of the worker. The income of a Sub S reported on Schedule K-1 does not count in determining the amount you may be able to contribute to a qualified plan. SIMPLE-IRAs and regular IRAs are also dependent on wages, but provide more flexibility with lower overall limits.

Some Examples

Example One
John is the sole shareholder of ABC Sub S Corporation that is going to have $50,000 of earnings this year. John is in a 35% tax bracket. He is considering taking no wages and having all the income reported on his K-1. If he takes the $50,000 as wages, his wages will have 6.20% withheld for Social Security and 1.45% withheld for Medicare. In addition, the company will pay the same amounts, but get a deduction for the $3825 it pays.

In total, John and the company will pay $7650 in payroll taxes, but save $1339 due to deducting the company deducting its share of payroll taxes. On a net basis, John and the company will have paid $6311 in taxes. If he takes no wages and has all the income flow through the K-1, he will have saved that money.

If John takes the income in wages, he would also be eligible to contribute to a qualified plan. Generally, he could contribute up to $12,500 (25% of wages) to a SEP-IRA or Keogh plan and save $4375 in taxes

Instead he could contribute $11,500 (the maximum) to a SIMPLE-IRA and the company supplies a 3% match resulting in total contributions of $13,000. In both cases, the additional payroll taxes are not offset by the benefit of a deductible contribution to a qualified plan.

Example Two
Same situation as above, but John only takes $11,500 of wages and uses a SIMPLE-IRA. The $11,500 of wages produces total Social Security and Medicare taxes of $1759 and saves $308 in income taxes due to the company deducting its share of payroll taxes. On a net basis, John and the company pay $1451 in taxes.

He then contributes $11,500 (the maximum) to a SIMPLE-IRA and the company supplies a 3% match resulting in total contributions of $11,845. In this case, the total income tax savings in the current year are $4146, which more than offset the payroll taxes. The SIMPLE-IRA has $11,845in it for the John's retirement and those funds enjoy tax deferred compounding until withdrawn. This would have been a good idea for John.

Higher Income and Age 50 Plus Situations
The interplay between payroll tax rates, the limit on wages subject to Social Security taxes, limits on contributions to qualified plans especially with the over age 49 "catch-up" contribution limits, and the individual's personal income tax bracket can make evaluating the possibilities complex. In addition, over the long term, the benefits of tax deferred compounding of earnings within a qualified plan are significant and may offset the current year "payroll tax cost." Depending on your situation, taking more of your income in wages may give you the best long-term result.

Conclusion
If you are a Subchapter S shareholder, have few if any other employees and can control how your total income is divided between wages and K-1 income from your Sub S, you probably should consider your options. The calculations can be complex, but your time (or that of your tax advisor) could be well spent.