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You are here: Home > Small Business KB > Small Biz FAQs > How can I avoid or reduce Self-Employment (SE) taxes?
  • Taxpayers Guide to LLCs and S Corps

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2023
      • Quick Reference 2024
      • Quick Reference 2025
    • Chap 1 - Business Entities, LLCs

      • Basic Business Entities
      • Sole Proprietorship
      • Single Member Limited Liability Company
      • Multi-Member Limited Liability Company
      • Partnerships
      • Being Considered a Passive Business Owner
      • Rental Partnerships
      • C Corporations
      • Personal Service Corporation
      • Professional Corporations and LLCs
      • S Corporations
      • Section 199A Qualified Business Income Tax Deduction
      • S Corp Versus LLC
      • LLC Popularity (Hype)
      • Formation of an LLC or S Corp
      • Nevada Fallacy of an LLC (or Delaware or Wyoming!)
    • Chap 2 - Customized Entity Structures

      • Your Spouse as a Partner (Happy Happy Joy Joy)
      • Family Partners
      • Real Estate Holding Company and Operating Company
      • Parent-Child Arrangement (Income Flows "Up")
      • Parent-Child Arrangement (Income Flows "Down")
      • Multi-Member LLC That Issues Invoices
      • Things to Work Through with Multiple Entities
      • Recap of Benefits with Multiple Entities
      • State Apportionment with Multiple Entities
      • California Multi-Member LLC S Corp Twist
      • C Corporation as Mothership
      • Holding Company versus Management Company
      • Pure LLC Holding Company
      • Economic versus Equity Interests
      • Structuring Deals with Angel Investors
      • ESOPs and S Corporations
      • Another Employee Ownership Situation
      • Medical C Corp
      • Fleischer Tax Court Case
      • Joint Ventures
      • Loans or Capital Injections
      • Using a Trust in Your Formation Considerations
      • Operating Agreements
      • Exit Plans, Business Succession
      • Liability Protection Fallacy of an LLC
      • Charging Orders
      • Using a Self-Directed IRA to Buy a Rental, Start A Business
    • Chap 3 - S Corporation Benefits

      • Avoiding or Reducing Self-Employment SE Taxes
      • Tax Savings with Health Insurance
      • S Corp Hard Money Facts, Net Savings
      • Ancillary Benefits with S Corporations
      • Officer Compensation with Solo 401k Plan Deferral
      • W-2 Converted to 1099
      • Net Investment Income, Medicare Surtax and S Corps
      • Being a Passive Business Owner
      • Three Types of Income
    • Chap 4 - The 185 Reasons to Not Have an S Corp or LLC

      • Chapter 4 Introduction
      • Additional Accounting Costs
      • Additional Payroll Taxes
      • SEP IRA Limitations
      • Trapped Assets
      • Distributing Profits, Multiple Owners
      • Other W-2 Income
      • State Business Taxes (Not Just Income Taxes)
      • Deducting Losses, Trapped Cash
      • Distributions in Excess of Shareholder Basis
      • Stock Classes
      • Vesting and Expanding Ownership
      • Bad Loans to the S Corp
      • Social Security Basis
      • Payroll Taxes on Children
      • C Corp to S Corp Problems
      • Going Concern
      • Recap of S Corp Downsides
      • Growing Business, Debt Service
    • Chap 5 - State Nexus Problems

      • Chapter 5 Introduction
      • Chapter 5 Disclaimer
      • Wayfair Case Part 1
      • Nexus Theory
      • Constitutional and Legislative Standards
      • Sales and Use Tax, Income Tax
      • Physical and Economic Presence, Nexus Attached
      • Wayfair Case Part 2
      • Services and Tangible Personal Property (TPP)
      • Costs of Performance, Market-Based Approach
      • Allocation and Throwback
      • FBA, Drop Shipments, Trailing Nexus Revisited
      • Recap of State Tax Issues
      • State Tax Issues and Nexus
    • Chap 6 - S Corporation Election

      • Formation (Election) of an S-Corp
      • Electing S-Corp Filing Status, Retroactive for 2025
      • Another Option, Dormant S Corp
      • Missing Payroll, Now What
      • Mid-Year Payroll
      • Nuts and Bolts of the S Corp Election
      • Ineffective S Corp Elections
      • S Corp Equity Section
      • Terminating S Corp Election
      • Distributed Assets
      • 5 Year Rule
      • Life Cycle of an S Corporation
    • Chap 7 - Section 199A Deduction Analysis

      • Section 199A S Corp Considerations
      • Calculating the Qualified Business Income Deduction
      • Section 199A Defining Terms
      • Specified Service Trade or Business (SSTB) Definitions
      • Trade or Business of Performing Services as an Employee
      • Services or Property Provided to an SSTB
      • Section 199A Deduction Decision Tree
      • Section 199A Reasonable Compensation
      • Section 199A Pass-Thru Salary Optimization
      • Cost of Increasing Shareholder Salary
      • Section 199A Rental Property Deduction
      • Negative Qualified Business Income
      • Qualified Property Anti-Abuse
      • Aggregation of Multiple Businesses
      • Section 199A W-2 Safe Harbors
      • Additional Section 199A Reporting on K-1
      • Section 199A Frequently Asked Questions
    • Chap 8 - Section 199A Examples and Comparisons

      • S Corp Section 199A Deduction Examples
      • Section 199A Side by Side Comparisons
      • Section 199A Basic Comparisons
      • Section 199A Health Insurance Comparison
      • Section 199A 200k Comparison
      • Section 199A 250k Comparison
      • Section 199A Specified Service Business Comparison Part 1
      • Section 199A Specified Service Business Comparison Part 2
      • Section 199A Phaseout
      • Section 199A Recap
      • Section 199A Actual Tax Returns Comparison
    • Chap 9 - Reasonable Shareholder Salary

      • Chapter 9 Introduction
      • IRS S Corp Stats
      • Reasonable S Corp Salary Theory
      • IRS Revenue Rulings and Fact Sheet 2008-25
      • Tax Court Cases for Reasonable Salary
      • Risk Analysis to Reasonable Shareholder Salary
      • Reasonable Salary Labor Data
      • Assembled Workforce or Developed Process Effect
      • RCReports
      • W-2 Converted to 1099 Reasonable Salary
      • S Corp Salary Starting Point
      • Multiple Shareholders Payroll Split
      • Additional S Corp Salary Considerations
      • Reasonable Salary Recap
    • Chap 10 - Operating Your S Corp

      • Chapter 10 Introduction
      • Costs of Operating an S Corp
      • New S Corp Puppy, What Do I Do Now
      • Accounting Method
      • 1099-NEC Issued to Your SSN
      • Take Money Out of the S Corp
      • Processing S Corp Payroll
      • Minimum Payroll with December Bonus
      • Taking Shareholder Distributions
      • Reclassify Shareholder Distributions
      • Accountable Plan Expense Reimbursements
      • Accountable Plan Requirements
      • Shareholder Distributions as Reimbursements
      • S Corp Tax Return Preparation
      • Distributions in Excess of Basis
      • Minimize Tax or Maximize Value (Economic Benefit)
      • Tracking Fringe Benefits
      • Other Tricks of the Trade with S Corps
      • Adding Your Spouse to Payroll
      • Chap 10 - Comingling of Money
    • Chap 11 - Tax Deductions, Fringe Benefits

      • Chapter 11 Introduction
      • Four Basics to Warm Up To
      • Section 199A Deductions – Pass Through Tax Breaks
      • 185 Business Deductions You Cannot Take
      • Depreciation
      • Small Business Tax Deductions Themes
      • Value of a Business Tax Deduction
      • Deductions the IRS Cannot Stand
      • Automobiles and LLCs, S Corps
      • Business Owned Automobile
      • Section 179 and Bonus Depreciation
      • You Own the Automobile, Get Reimbursed By The Mile
      • You Own the Automobile, Take Mileage Deduction
      • You Own the Automobile, Lease Back to Your Company
      • Automobile Decision Tree
      • Home Office Deduction
      • Tax-Free Rental of Your Home
      • Tax Home
      • Business Travel Deduction
      • Deducting Business Meals
      • Sutter Rule
      • Cohan Rule
      • Capital Leases versus Operating Leases
      • Putting Your Kids on the Payroll
      • Educational Assistance with an S-Corp - Section 127
      • Summary of Small Business Tax Deductions
      • Business Tax Return Preparation
      • Comingling of Money
      • Reducing Taxes
    • Chap 12 - Retirement Planning

      • Retirement Planning Within Your Small Business
      • Self Employed Retirement Plan Basics
      • Retirement Questions to Ask
      • Tax Savings and Tax Deferrals
      • Using a 401k in Your Small Business Retirement Options
      • The Owners-Only 401k Plan
      • Having Staff with a Solo 401k Plan
      • Self-Directed 401k Plans
      • Company-Sponsored 401k Plan
      • 401k Plan Safe Harbor Provision
      • Roth 401k Plans
      • Roth 401k Versus Traditional 401k Considerations
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
      • 401k Loans and Life Insurance
      • 401k Plans and Roth IRA Conversions
      • Turbo Charged 401k Plans
      • SIMPLE 401k
      • SEP IRA
      • SEP IRA, Roth IRAs and the Roth Conversion
      • Controlled Groups
      • Owner Only 401k Plans in MMLLC Environment
      • Spousal Attribution and Controlled Groups
      • Non-Qualified Deferred Compensation Plan
      • Exotic Stuff
      • Expatriates or Expat Tax Deferral Planning
      • Small Business Retirement Planning Recap
    • Epilogue

      • WCG Fee Structure
      • More About WCG
      • Consultative Approach
      • Core Competencies
      • No BS
      • Expectations of Our Clients
      • Final Words
    • Chap xx - Health Care

      • Disclosure and Updates
      • Gaming the HSA System
      • Health Care Summary
      • Health Savings Accounts (HSAs)
      • Long-Term Care
      • Multiple Employees
      • One Person Show or Husband-Wife Team, S Corporation
      • Section 105 Health Reimbursement Arrangement (HRA)
      • Section 125 Cafeteria Plans and Flex Spending (FSA)
      • Sole Proprietors and Single Member LLCs
    • Chap yy - Business Valuations, Sale, Exit Planning

      • Business Valuation Techniques
      • Buy-Sell Agreements
      • Deal Structure
      • Debt Service
      • Exit Plans, Succession
      • Purchase Price Allocation
    • Chap zz - Other S Corp Thoughts

      • 1099 Income as Other Income, No Self-Employment (SE) Taxes
      • Audit Rates and Risks with an S-Corp
      • Recap of S-Corps
      • Rental Losses with an S-Corp
      • Rentals Owned by an LLC Fallacy
      • W-2 or 1099-MISC That Is The Question
  • Expat and Expatriate KB

    • Expat FAQs

      • Are there any downsides to claiming the foreign earned income exclusion?
      • Are there exceptions to the bona fide residence or physical presence tests?
      • As an ExPat, do I need to file a State tax return?
      • Can I deduct mortgage interest paid on my foreign home?
      • Do I have to pass the same test each year?
      • Does voting through an absentee ballot mess up my bona fide foreign residency?
      • How do fluctuating currency values affect my taxes?
      • How do I handle my foreign rental property?
      • How do I qualify for the foreign earned income exclusion?
      • How do moving expenses affect my exclusion?
      • How do partial years work with the foreign earned income exclusion?
      • How do tax treaties affect my ExPat situation?
      • How does the foreign housing exclusion or deduction work?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If I don't qualify for the housing deduction, can I still deduct expenses?
      • May I still make contributions to my IRA as an ExPat?
      • What amount can I deduct for foreign earned income exclusion?
      • What happens if my host country has a form of social security?
      • What is a tax home or abode, and how do they relate to each other?
      • What is considered foreign earned income?
      • What is foreign earned income exclusion?
      • What is the bona fide residence test?
      • What is the difference between foreign tax credit and deduction?
      • What is the physical presence test?
  • Rental Property KB

    • Rentals FAQs

      • Can I claim my residence as a rental, sell it for a loss and deduct the loss?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Can I deduct the taxes associated with public improvements?
      • Can I rent out half a duplex or a room in my house?
      • Do I need receipts for my rental expenses?
      • Do rental properties offer good tax sheltering?
      • How are repairs and improvements different?
      • How do I handle my foreign rental property?
      • How do passive loss limitations affect me?
      • I purchased a rental property last year. What closing costs can I deduct?
      • If I don't have any rental income can I still claim a loss?
      • If I move back into my rental, how does that work?
      • If my employer provides a cell phone, is that income?
      • Is depreciating my rental a good thing?
      • My rental sale was a huge loss. What can I do?
      • Rentals Owned by an LLC Fallacy
      • What are tax issues with an LLC owning a rental property?
      • What are the exceptions to rental activities?
      • What are the rules on a home office deduction?
      • What is active participation versus material participation?
      • What is considered rental income?
      • What rental property expenses can I deduct?
    • Real Estate Pros

      • Are rental activities always passive activities?
      • Are there downsides to the real estate professional designation?
      • Are there specific material participation tests for real estate professionals?
      • Do I need to group my rental activities together?
      • How do I record the hours spent as a real estate professional?
      • If I meet the 750-hour test, do I also meet the 500-hour material participation test?
      • What activities count and don't count?
      • What are some of the IRS tricks to deny my real estate professional designation?
      • What are some of the tax court cases for real estate professionals?
      • What are the general tests for material participation?
      • What is active participation versus material participation?
      • What is the definition of real estate professional?
      • Why designate myself as a real estate professional?
  • Other Tax Information KB

    • Audits

      • Can I ignore an IRS notice or claim I never received it?
      • How can I pay my taxes or my notice of deficiency?
      • How can I prepare for my face to face or interview field audit?
      • How do I appeal the collections of unpaid taxes?
      • How does a joint return get handled during an audit?
      • How does bankruptcy affect my unpaid taxes?
      • How much is interest and penalty on taxes owed?
      • How should I respond to an IRS notice or letter?
      • What are my chances of being audited?
      • What are some of the types of IRS notices and letters?
      • What can the IRS do if I don't pay my taxes- what is the collections process?
      • What causes or triggers an IRS audit?
      • What if I cannot pay my taxes?
      • What IRS publications deal with audits?
      • What is the appeals process?
      • What is the period of limitations for an audit?
      • What types of audits could I face?
      • Who can be with me at my IRS audit or conference?
    • Charitable Contributions

      • Are there ways to earmark money for an individual?
      • Do I need receipts for my donations?
      • Does deducting charitable contributions cause an audit?
      • How do I determine the value of my donation?
      • What are some of the donations I can deduct?
      • What are some other charitable deductions?
      • What are the limits of my donations?
      • Who qualifies as a charity?
      • Why give to charities?
    • Education, Tuition Deductions

      • Are Educational Savings Accounts Worth It
      • Are There Tax Breaks for Going to College
      • Are There Tax Savings When My Employer Pays for My Education
      • Can I deduct the cost of sports, games or hobbies while in college?
      • IRAs and Savings Bonds To Help With Higher Education Costs
      • What College Expenses Can I Deduct From My Income
      • What constitutes a full-time student for tax purposes?
    • Homes and Real Estate FAQs

      • Can I deduct the loss on my primary residence?
      • Can I deduct the taxes associated with public improvements?
      • Can I exclude the gain on my home sale?
      • How does a Federal Disaster affect my casualty loss?
      • My home was destroyed- what deduction can I take? How do casualty losses work?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What are the rules on a home office deduction?
      • What is Cancellation of Debt? Is it taxable income?
    • Medical, Health Insurance

      • What are qualified medical expenses?
      • Why can't I deduct health insurance premiums?
    • Mortgages, Bad Debts

      • Can I deduct a bad debt on my tax return?
      • Can I deduct the loss on my primary residence?
      • Is cancellation of debt always taxable?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What is Cancellation of Debt? Is it taxable income?
    • Recordkeeping

      • Are there specific records I need to keep?
      • Do I need receipts for my expenses?
      • How does proper recordkeeping affect my audit results?
      • How long do I have to keep records?
      • How should I maintain my tax records?
      • What are the requirements for mileage records?
      • Why should I keep tax records?
    • General Tax Questions

      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • If my employer provides a cell phone, is that income?
      • Tax Brackets Misconceptions- Should I earn more money?
      • What is the marriage penalty and how does it affect our tax returns?
  • Small Business KB

    • Small Biz FAQs

      • Hobby Versus Business

        • 3 out of 5 Test
        • Hobby Versus Business Testing
        • Philosophy of Business Losses
        • Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
        • WCG (formerly Watson CPA Group) Philosophy on Hobby Losses
      • Independent Contractors

        • Behavioral Control
        • Colorado's Criteria for Contractor Status
        • Employee or Independent Contractor
        • Employee or Independent Contractor Status
        • Financial Control
        • IRS Determination, Form SS-8
        • Misclassified Workers Can File Social Security Tax Form
        • Salespeople As Contractors
        • Sample Response to CO Unemployment Claim
        • Statutory Employee and NonEmployees
        • Tax Court's Checklist
        • Type of Relationship
      • LLC and S-Corps (superseded)

        • As a one-person show, should I still form an LLC? An S-Corp?
        • Automobiles and LLCs, S Corps (superseded)
        • Can I call my 1099 other income which avoids employment taxes?
        • Determining the S-Corp Payroll Amount
        • Estimated Tax Payments, Withholdings Issues for an S-Corp
        • How do I convert my LLC to an S-Corp?
        • How does an LLC or S-Corp's income affect my taxes?
        • If the S-Corp taxation is what I ultimately want, should I form an LLC or C-Corp?
        • Is there a way to avoid Self-Employment tax?
        • Should I convert my LLC to an S-Corp (Sub-S Election)?
        • Should I form an LLC with my spouse?
        • The S-Corp Grind, Operational Hassles
        • The Zero Dollar Paycheck
        • What are the operational hassles of an S-Corp LLC?
        • What is an Accountable Plan?
        • The Money Trail for S-Corp Elections
        • 185 Reasons NOT to S-Corp, Downsides to S-Corp Election
      • Can I call my 1099 other income which avoids employment taxes?
      • Can I deduct country club dues as a business expense?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Health Care Expenses, Premiums, HRAs, HSAs - Section 105
      • Hobby Versus Business Article
      • How can I avoid or reduce Self-Employment (SE) taxes?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If my employer provides a cell phone, is that income?
      • LLCs and S-Corps
      • Retirement Planning within an S-Corp
      • S-Corp Hard Money Facts, Net Savings
      • Turn Your Vacation Into a Tax Write Off
      • What are tax issues with an LLC owning a rental property?
      • What are the rules on a home office deduction?
      • What business or corporate expenses can I deduct?
      • What do I do with a 1099-K?
      • What is the difference between a hobby and a business?
      • What is the difference between an LLC, S-Corp and a C-Corp?
      • Why can't I deduct health insurance premiums?
  • Archive

    • Articles coming soon
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  • How can I avoid or reduce Self-Employment (SE) taxes?
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How can I avoid or reduce Self-Employment (SE) taxes?

By Jason Watson (Google+)

*** This is legacy information. Please see our completely revamped and really cool book on this ***

https://wcginc.com/business-formation-services/s-corp-election/

Avoiding or Reducing Self-Employment (SE) Tax
A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self-employment taxes or SE taxes? Yes, to a large extent actually but it takes some effort.

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-

wcginc.com/SubS.pdf

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)-

Income LLC SE Tax S Corp
Payroll Tax
Delta % Savings
 $30,000  $3,685  $2,295  $1,390 4.6%
 $50,000  $6,141  $3,825  $2,316 4.6%
 $75,000  $9,212  $5,738  $3,475 4.6%
 $100,000  $12,283  $7,650  $4,633 4.6%
 $150,000  $15,468  $11,475  $3,993 2.7%
 $200,000  $16,807  $15,300  $1,507 0.8%

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
So, when your partnership, LLC or corporation is an S-Corp you are both an employee and a shareholder (think investor). As an employee, your income is subjected to all the usual taxes that you would see on a paystub- federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment and disability. However, as a shareholder or investor, you are simply getting a return on your investment much like a dividend. That income, as the Romneys, Gates and Buffets of the world enjoy, is a form of investment income and therefore is not subjected to self-employment taxes (tiny exception for income over $200,000 where Medicare tax is charged).

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
In creating the table above we prepared fictitious tax returns to get exact numbers. At $75,000 in net income an S-Corp will generally save about $3,475 in self-employment taxes. If you use WCG (formerly Watson CPA Group) for your payroll and corporate tax preparation needs, our fee will generally be about $1,200 (give or take $200 depending on your unique situation). So some of the $3,475 is lost in additional accounting expenses but you could easily save $2,200 after it is all said and done, and the extra effort is minimal.

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
There is a misconception floating around out there that an S-Corp is a standalone entity. Not true. There are basically three broad types of entity formation- Partnerships, Limited Liability Companies (LLCs) and Corporations (C-Corps). Each can elect to be treated as an S-Corp for taxation purposes only under subchapter S of the revenue code, but the underlying entity and subsequent corporate governance is either a Partnership, LLC or C-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
Not everything that glitters is gold so there are a handful of downsides, some manageable, to the S-Corp election. A lot of these examples stand alone, and some of these depend on the net income of the business. We can help guide you through the decision-making process.

Please read the expanded KB Article on the disadvantages or downsides to the S-Corp election. Here is a summary-

  • Additional Accounting Costs
  • Possible State Income Taxes
  • Deducting Losses Could Be Limited
  • Distributing Profits
  • Other W-2 Income
  • Social Security Basis
  • Payroll Taxes on Children

Operational Hassles of an S-Corp
You’re probably thinking that running an S-Corp adds all kinds of burdens. There are very few operational hassles with an S-Corp. All the things you do now to maintain your financial records remain the same. And the things you do in terms of corporate governance such as meetings, minutes and voting, also remain the same.

The two other requirements are paying a reasonable salary through payroll and preparing a corporate tax return. And if you use WCG (formerly 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 several factors to consider when coming up with a reasonable salary. The IRS through Fact Sheet 2008-25 released a less than helpful laundry list (last update was in 2008). Guidance is poor, and typically we start off at 50% of net income. There are some other tricks of the trade that will be explained later (accountable plans, salary shifting, etc.).

Running Payroll
As far as actually writing paychecks, WCG (formerly Watson CPA Group) offers bookkeeping and payroll services. Here is the typical individual pricing, and the discounts for combining some services-

Corporate Tax Return Only $375 to $775 depending on the quality of your books
Quarterly Bookkeeping $200 to $400 per quarter
Quarterly Payroll $150 per quarter, 1-5 employees
Monthly Bookkeeping $150 to $300 per month
Monthly Payroll $125 per month, 1-5 employees
W-2 Preparation $75 per year, 1-5 employees

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
Estimated tax payments change as well when you have an S-Corp. When computing your estimated tax liability for the quarter you must include the taxes (income and employment taxes) that will be withheld from your paycheck.

Corporate Tax Return
An S-Corp must file a corporate tax return by March 15 and there are additional financial reporting requirements. However, if you use WCG (formerly Watson CPA Group) to prepare your tax returns and we’ll make it seamless and pain free. Ok, taxes and pain free don’t really go together, but you get the idea.

Determining the Payroll Amount
As an S-Corp, you are taking money out of the business in four ways-

  • Wages,
  • Rent paid to you by the S-Corp for the use of your assets (this is getting more rare),
  • Reimbursements through an Accountable Plan, Health Expenses, Education Assistance, and
  • Shareholder distributions.

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
Every situation is different, however the backward looking method of determining your paycheck offers the best flexibility for S-Corps, especially with fluctuating cash flows and profit levels. For example, you earned $20,000 for Q1 and you withdrew $20,000 in cash over the quarter. For Q1’s payroll, we would re-classify $10,000 as wages and run that through payroll, but we would create an employee deduction back to the company so the paycheck would be $0. Therefore only taxes are being withdrawn from your account, and not an entire wage plus taxes.

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
One of the goals of any business owner is to be able to pull money out of the company without creating a taxable event. There are four big ways to accomplish this-

  • Reimbursements for Out of Pockets Business Expenses (Accountable Plan)
  • Fund Your Retirement Account
  • Reimbursements for Health Insurance Premiums, Expenses
  • Paying for an Employee’s Education

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-

wcginc.com/LLC.pdf

For a sample Accountable Plan form that you can use-

wcginc.com/AccountablePlan.pdf

Retirement Planning within an S-Corp
There are lots of options with retirement planning within your S-Corp. 401ks, SEPs, SEP conversions to Roth IRAs, etc. There are also several options and combination of options, and we can work with your financial advisor to settle into the best plans.

Health Care Expenses, Premiums, HRAs, HSAs
An S-Corp allows you set up a plan to reimburse shareholders (and employees) for medical premiums and expenses plus make contributions to a Health Savings Account (HSA).

Health Insurance Premiums
In IRS Notice 2008-1 premiums paid under individual medical and health insurance plans may be deductible on your personal tax return (the usual Form 1040). By including the cost of health insurance as wages in Box 1 on your W-2, the S-Corp gets a “wage expense” deduction, which in turn reduces the K-1 income for all shareholders (but each shareholder gets comparable a bump in W-2 income as a part of his or her reasonable salary).

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)
Also, an S-Corp can also adopt a Section 105 Health Reimbursement Arrangement (HRA). By adopting an HRA you can maintain your current reasonable salary yet reclassify a portion of it (and perhaps a large portion of it) as reimbursement for health care expenses.

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
Your S-Corp can pay up to $5,250 of an employee’s tuition and education expenses including your children who work for the S-Corp. But there are some rules for your child. He or she must-

  • Be age 21 or older,
  • Be a legitimate employee of the S-Corp,
  • Not own more than 5% of the S-Corp, and
  • Not be your dependent.

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
First you must be eligible to become an S-Corp for taxation purposes. Second, Form 2553 (the S-Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity, however, there is relief for the late filing of Form 2553 and we can guide you through that (IRS Revenue Procedures 2003-43 and 2004-48).

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
The big theme with S-Corps is payroll for shareholders, and what constitute reasonable payroll as an overall percentage of net income. There are some tricks that you can consider to help reduce, lower or avoid self-employment tax, or Social Security and Medicare tax burdens. Lop siding salaries between owners, putting kids on payroll, income splitting, health insurance, etc. Please read the full KB Article on this topic or our S-Corp Tax Article at-

wcginc.com/SubS.pdf

Car Ownership, Paying Rent, Home Office Deduction
When you own 2% or more of an S-Corp, the rules dramatically change when it comes to car ownership, paying rent for shareholder assets and home office deductions. In response, most tax professionals have favored an Accountable Plan that simply reimburses the shareholder for out-of-pocket expenses. There is more detailed information about Accountable Plans, and how they can help pull money out of the S-Corp to pay for mileage, home office, cell phone, internet, etc. Please read our tax article on LLCs-

wcginc.com/LLC.pdf

For a sample Accountable Plan form that you can use-

wcginc.com/AccountablePlan.pdf

Audit Rates and Risks with an S-Corp
There are audits risks with any business form, and for any taxpayer. Typically taxpayers under $200,000 in income face a 1% audit risk. And S-Corps face a 0.42% audit risk.

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
Here is a quick recap or summary of S-Corps, and why you might consider making the election-

  • Must have an LLC or C-Corp in place
  • Can save 4.6% of net income on taxes
  • Must run payroll and prepare a corporate tax return
  • Payroll can be ran quarterly, previous distributions can be reclassified as wages
  • Pull money out with reimbursements for business expenses (home office, mileage, etc.)
  • Hefty retirement contributions allowed, reduces income
  • Health Reimbursement Arrangements (HRA) give dollar for dollar deduction
  • Pay for your children’s college expenses through the S-Corp
  • Can retroactively make the S-Corp election for 2013
  • Low operational hassles
  • Approximately $1,200 in extra accounting costs for tax preparation and payroll (your mileage may vary)

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?

S-Corp Consultation
WCG (formerly Watson CPA Group) provides initial S-Corp consultation for $150, for up to one hour. We can provide the consultation in person at our offices, teleconference or Skype, whatever is easier for you. If you become one of our clients, we will discount any additional services by $75 to help offset the initial consultation fee.

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!

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