By Dr. James M. Dahle, WCI Founder
Credit for the inspiration behind this post goes out to poster “spiritrider” from the WCI forum, who taught me something new about S Corporations. Luckily for me, it doesn't apply to our S Corporation (WCI, LLC), but it might very well apply to your S Corporation. More on that later, but first, let's review some basic facts about S Corps.
What Is a S Corporation?
Technically, there is no such thing as an S Corporation and a C Corporation. There is only a corporation and some corporations have filed an “S declaration”. The S stands for “Small”, as in a small business.
Benefits of a S Corp
The main advantage of declaring your corporation an S Corporation for tax purposes is that it eliminates a level of taxation. A corporation (i.e. a C Corp) has its own set of tax brackets. Salaries paid to employees become business expenses (and thus non-taxable), and those employees have to pay regular earned income taxes on those salaries. Any additional money paid out to the owners is paid out as a dividend, which is often “qualified” with the IRS for the lower dividend tax brackets instead of the regular tax brackets.
S Corps and Taxes
If the corporation makes an S declaration, it is no longer subject to the corporate level of taxation and becomes a “pass-thru entity'. That means the taxes are passed through onto the corporation shareholders' individual returns. There is still a corporate return, but there is no payment made as a corporation. That's not the main reason why many doctors and small business owners choose S Corporation taxation though. The main reason is they can use it to split their income into salary and distribution. The main benefit of paying yourself as much of the corporate income as distribution as possible is that you don't have to pay payroll taxes (i.e. FICA, Self-employment or Social Security and Medicare taxes) on the distributions. However, you want to make sure you pay yourself enough of a salary to stay out of trouble with the IRS. That means you need to pay the going rate for your services. Of course, there's often a lot of gray in what is a reasonable salary, and S Corp owners generally take advantage of that fact. You probably want to make sure you pay yourself enough to max out any retirement accounts and take full advantage of the Section 199A deduction (i.e. the pass-thru business deduction).
What About LLCs?
The IRS disregards Limited Liability Companies (LLCs) when it comes to taxation. The single member LLC is taxed as a sole proprietorship and a multi-member LLC is taxed as a partnership UNLESS the LLC opts to be taxed as a corporation (and it often does so in order to then make an S declaration.) The benefits of the LLC are that it is simpler and cheaper to administer than a corporation, provides similar liability protection, and can still get S Corp style taxation.
Do LLCs or Corporations Protect Doctors from Malpractice?
Not really. But they could potentially protect you from the malpractice of one of your employees if the business is also named in the suit. As a general rule, malpractice is personal and you can't hide behind an LLC or corporation. They do provide some protection from other business liabilities though.
How Much Does an S Corporation Have to Pay Me to Max Out My Individual 401(k)?
It depends on whether you've already used your employee contribution ($18,500 if under 50, $24,500 if over) in another 401(k) already. In 2018 the grand total that can go into an individual 401(k) for someone under 50 is $55,000. If you are under 50 and haven't used your employee contribution elsewhere, you can put $18,500 in there as an employee contribution and then 25% of salary as an employer contribution. Bear in mind the business actually has to make enough money to make the employer contribution in addition to your salary, so in reality, you can't contribute more than 20% of what the business made.
$55,000 – $18,500 = $36,500
$36,500 / 25% = $146,000
So the business must pay you at least $146,000 for you to max out that i401(k) (and must make at least $182,500 after expenses including the employer half of your payroll taxes.)
If you already used that employee contribution elsewhere, then the whole $55,000 must come as an employer contribution.
$55,000 / 25% = $182,500
At least prior to 2018, assuming you could justify it as a reasonable salary, there was no reason to pay yourself more than those amounts because every additional $1,000 that gets paid as salary costs $29 (half of which is tax-deductible) in Medicare taxes.
How Do You Balance Salary, Medicare Tax, and the 199A Deduction as an S Corp?
So the more you pay yourself as an employee, the more Medicare tax it costs you. However, if you qualify and are above the phaseout limit ($157,500-207,500 Single, $315,000-415,000 married in TAXABLE INCOME) for the Section 199A (Pass-thru Business, 20% of business income) deduction, there is a limitation on that deduction to 50% of salaries paid to your employees. If you're the only employee, paying yourself more salary can actually increase your Section 199A deduction and lower your overall tax bill despite paying more in Medicare taxes. Crazy, I know. But the algebra works out to be that you ideally want to pay yourself about 28.6% of what the business makes as salary. Again, I want to emphasize this has to be reasonable compensation for what you do and you probably want it to be enough to max out your retirement accounts. These are the factors the IRS looks at to determine that (although I don't get the impression they look very hard unless your compensation is particularly egregious):
The three major sources [of gross receipts for the corporation] are:
- Services of shareholder,
- Services of non-shareholder employees, or
- Capital and equipment.
If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee's personal services and it is reasonable that the shareholder would receive distributions along with compensations.
On the other hand, if most of the gross receipts and profits are associated with the shareholder's personal services, then most of the profit distribution should be allocated as compensation.
In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.
Some factors in determining S Corp reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
An S Corp Can Also Increase Your Payroll Taxes
Here's where we get to spiritrider's tip. By the way, this little IRS rule stinks and is totally unfair, so don't ask me to defend it. The way payroll taxes work is that if you work for two separate employers, they both collect payroll taxes for you (including Social Security on the first $128,400 in 2018 that each employer pays you.) The employer sends both their half and your half to the IRS. Obviously, this results in you overpaying Social Security taxes if you work for two employers each paying you $128,400 when compared to working for one employer from whom you are paid $256,800. Well, the IRS cares about you and there is a way you can claim a refund of those extra Social Security taxes that you paid, i.e. the employee half. It is claimed on line 71 of the 1040 and can be figured using Table 3-1 in Publication 505. However, the IRS does NOT care about your employer and there is no way for the employer (or you) to get the employer half of the overpaid Social Security taxes back. Which really stinks if you are the employer AND the employee like many S Corp owners.
There is a workaround if the businesses are highly related (basically same owners and employees) and share a “common paymaster” and for successor businesses. However, these workarounds aren't going to apply to the typical doc who is employed by a hospital and then by himself to do some moonlighting on the side. That doctor may very well NOT want to form an S Corp (or declare his LLC an S Corp for tax purposes) because it would result in him paying MORE in payroll taxes, instead of less. Sucks huh?
This doesn't apply to my business (because I am only an employee of ONE business- WCI, LLC) but it could apply to yours. So make sure you study this carefully when deciding whether or not to do the S Corp thing.
One possible option would be to change your employment status with your hospital to being an independent contractor and then run all your income through your S Corp, but this would keep you from using multiple 401(k)s.
Want to learn more about setting a salary for an S Corp? Check out Stephen Nelson's book on the subject:
Setting Low Salaries for S Corporations
What do you think? Are you an S Corp? Why or why not? Comment below!
Man, that is painful. This is not my area of interest at this time, but do have a question.
Since the FICA payroll limit stops at $128,000 for the social security portion and you recommend at least paying yourself enough to fill up a 401K (~$180,000), doesn’t calling everything above that a “distribution” only save you the medicare tax rates of 2.9%?
I am not putting my nose up at saving 2.9% on my tax bill, but it is certainly a lot less than the 15.3% you’d save if you started calling things a “distribution” before the $128,000 social security limit and invested in the difference in a taxable account.
Say for example, the average income of a blogger is $50,000 and the site earns $100,000. Why not call the extra $50,000 a distribution, save the full 15.3% on that and invest the difference in a taxable account or use that to fill up your backdoor Roth? I guess this would involve some math to determine what I think my tax rate will be when I retire and if it’s at least 13% lower than what it is now, I’d be better off putting pre-tax money into a 401K than using the distributions in a taxable account.
Seems like the math (and ability to predict the future) get complicated quickly.
What am I missing?
@TPP I think one issue is that if for example you are an employed doc with a side hustle, you may be in a much higher marginal tax bracket – so deferring tax on 20% of your side hustle income (employER contribution) may well be worth paying 3% in Medicare tax. Different brackets so different math for a blog income of 100k.
Yes.
Good luck convincing the IRS your physician services are worth less than $128K a year.
The problem with your example, at least for this blogger, is that pesky clinical income (not to mention he makes more than the average blogger.) But sure, in your hypothetical example, call $50K a distribution.
I should have been more specific. The 128K comment was not directed towards clinical work. I recognize there is no way that the government would view the field of medicine that way.
I was talking specifically about side hustle income through something like a blog.
TPP
To answer Physician Philosopher’s question, an S corporation saves a shareholder employee paying a salary equal to the FICA max either 2.9% or 3.8%… (That 3.8% is NIIT.) And for high income professionals, that can add up. E.g., many practitioners think you don’t need to go above the FICA limit, $128,400, so someone making $500K saves that tax on nearly $400K.
Also, one thing that many folks miss about the payroll tax savings angle is that it’s not just about the salary. Non-taxable fringe benefits play into the reasonable compensation optics in a big way. (These push up the compensation and save both payroll taxes and income taxes when the business operates as an S corporation.)
BTW, we do a couple hundred S corporation tax returns a year…
Steve doesn’t mention it, but he’s also the author of a popular 100pp monograph about S corporation salaries:
Setting Low Salaries for S Corporations:
Just a nit …
$55,000 / 25% = $220,000, not $182,500 as in the article.
I Really wish that it were practical for me (a non-medical professional) to take advantage of the S-CORP.
Did you account for the $18,500 employee contribution? $55K-$18.5K = $36.5K
$36.5K/25% = $146,000
Of course, the business must make another $36.5K to actually make the contribution. $146K + $36.5K = $182,500
Another example of why a consumption tax would be so much better than income tax (eg The Fair Tax book).
Do you really think we’ll get a VAT in lieu of the income tax rather than in addition to the income tax?
Once the Democrats hear that it brings in more tax revenue and the Republicans hear that it’s regressive, we’re all but guaranteed to get a VAT!
I’d prefer it, but I’m not holding my breath. More likely we’d get an income tax AND a consumption tax.
Where do the over withheld SS taxes end up in the last example? They can’t just get dumped into a government slush fund somewhere.
Why can’t they?
Social Security Trust Fund is actually a separate fund.
It is not a slush fund.
Employers report total compensation, FICA compensation, non-fica compensation, employee FICA, employer FICA and deposit the total listing each paycheck period. No reporting by employee, only entity. Annually, W-2’s are filed for each employee with a W-3 for the company (has to balance to the deposits reported for all the payrolls.
The FICA limit is by pay date. Two independent employers can’t coordinate when the limit is reached. Thus, which company gets the refund or how much?
Each company pays federal withholding, Social Security, and Unemployment by each payroll with different requirements. Some folks may have 5 W-2’s. Thus, no refund to the employers.
When the IRS gets 5 W-2’s, those sync up with the employers filing W-3 that proves overpayment. Employee gets it refunded. A common paymaster pays one employee for multiple businesses, one Employer filing as if it was one company.
Pre-tax retirement funding contribution limits for an individual are the total for the year, so no advantages.
One topic you neglected to cover is business expenses. Ordinary and necessary business purpose is the basic for a corporation of any type. Itemized deductions on a personal return have a different set of rules. Setting up credit cards, loans, insurance, professional fees, and operating expenses add up. Having separate checking and a set of books can allow a lot of expenses to be deducted. A lot of gray areas can be used if one uses a corporate structure simply because a business is treated differently than an individual.
You don’t need a corporation to claim business expenses. A sole proprietor can deduct them on Schedule C.
My understanding of the Social Security Trust Fund is that it is full of IOUs like that scene in Dumb and Dumber. i.e. there’s no money there. Current obligations are paid from current revenue, not money that was saved up from when you contributed it 20 years ago.
Yes it is not cash. My understanding is it’s actually different government debt instruments. The same trade like t-bill’s and notes. I guess if dumb and dumber really are worthless, then we might as well not worry about dollars .
The IOU’s are where funds have been “swiped “ into other accounts. Quite honestly, it’s not a bad debt. You are correct that it is not an insurance or pension account where funds are kept on deposit . But that’s the forecast you hear about running out of money when funds on hand . Current withholdings 20 years ago exceeded payments. 20 years from now, the balance will be zero. The “IOU’s” are senior to government bonds.
Interesting about the seniority.
Thanks for the write up. I’ve been contemplating changing from sole-proprietor to s-corp for a while and was hoping you could help me understand the pass-thru tax effects a little better.
Some sample numbers for example: Married filing joint with my business income of 350k and wifes W2 150k for gross income of 500k, and taxable income of 375k. With these numbers I’d be getting phased-out of the pass-thru deduction and only getting a partial deduction. And if our collective taxable income is >415k then no deduction.
Based on the above post it seems like an S-corp would allow me to deduct 20% of 50% of business salary even if taxable income is >415k. Is this correct? I understand there’s potential savings from medicare tax, but this can provide a significant deduction if I’m understanding it correctly.
Thanks
Not if it is a service business. Just making it an S Corp doesn’t change the rules on that.
Got it, no pass-thru benefit as a physician.
Thanks for the quick reply
Michael,
I would suggest you double-check your taxable income and make sure you’ve got all your deductions: self-employed health insurance, HSA, half of self-employment taxes, 401(k) or SEP, itemized deductions, etc. It seems like you could possibly be a little bit high with your taxable income number…
Also, you might want to look at really pushing down your taxable income if its possible with more aggressive deductions. (Legitimate ones of course.) Could you, for example, move to a defined benefit pension plan and thereby bump your $50K ish solo 401(k) deduction to a $100K ish DB contribution?
These changes might mean you end up adding the $63K Sec. 199A deduction to your return. Just an idea…
Great write up WCI and Spiritrider. Thanks.
I have recently switched from an S Corp to a sole proprietor. This has saved me a fair share in taxes and expenses while still getting the benefits of being a small business
It SAVED you taxes? That’s odd. How do you explain that?
Isn’t sole proprietor form of business has the least asset protection in the eyes of law, vs LLC/S copr/C corp? Not trying to jinx you here!
It’s obviously very state dependent, but in general, yes, an LLC and a corporation generally provide superior asset protection benefits.
If you are planning to start a small business, being an S-Corp brings limited liability for your company. This simply means that the company itself will be held liable to clear debts and other finances instead of the investors and shareholders.
You also need to keep two more things in mind. First, that there can be restrictions to who and who can not own your SME. This is usually a problem in case you want to expand operations later.
LLCs and S Corps not only protect against litigation, they also shield you from excessive taxation. For one, you can deduct pre-tax expenses under an LLC or an S Corp, reducing your overall tax bill.
You can do that with a sole proprietorship. You’d think someone who owns a site called Fast Inc Now would know that.
At what AGI / income should I consider switching from sole proprietor to S corp? 250? 300? 350?
Assuming 100% of the income is IC, hospital doc contract/ side hustle, married filing jointly, and eligible for the 199a deduction.
a threshold number would be very helpful in decision making!
Thank you for this thoughtful and well written article and thank you very much for what you do.
I don’t think I’d bother doing it below $300K in your situation, but I suppose someone else could argue that down to $200K or so.
Hey Jim,
I have a 2 part question:
1. Could you please elaborate on this 28.6%? What aspects are being considered to acquire this figure? Would you mind if I see the equation as well?
2. In 2018 my S Corp brought in 318K (no deductions considered in this figure). I’m married. 28.6% comes out to 91K. I am currently on track for a W2 of 148K so I can max out my Solo 401K. I understand your 50% W-2 rule recommendation to avoid IRS problems. I also see your recommendation to max out my Solo 401K. That said, I’m wondering if the math alone works out such that I would be better off (purely from a mathematical perspective not considering potential IRS issues) paying myself the 91K W2 and adjusting the Solo 401K contribution accordingly. I’m wondering if, purely from a mathematical standpoint, that money (which would have otherwise gone into my Solo 401K might be better off in a taxable account or even a syndicated investment (in part to reap associated tax benefits).
1. Basically it’s all about weighing the 199A deduction against the additional Medicare tax. The equation may be worth an entire blog post. It was actually a reader who did it for me, but I don’t recall which blog post it was posted on as a comment.
2. In your case, I agree it would be wise to max out that Solo 401(k). Also tough for a doc to argue for a $91K salary.
Very comprehensive article, thank you. I enjoyed the read.
One thing I could humbly add would be that an LLC taxed as a partnership might be best (instead of s corporation) for a high paid group, who also have w2 employment elsewhere, looking to be paid amounts based on how much they work for the company.
(You did mention the excess employment tax situation)
Its sounds like it would be rare but it’s very common with physician groups., dentists, etc
This way, the SE tax is capped and no excess employer taxes. Also no issue with ownership share vs share of profits.
Anyway, great post imo, thanks again.
An excellent point.
So, if an LLC can be taxed as an S-Corp, and the advantages of S-Corp are primarily tax based, why not just go with LLC and save the extra expense of forming an S-Corp?
Exactly. Most do (including WCI, LLC), but there are a few things you can only do with an S Corp.
Hi all,
Great discussions! Really enjoyed reading it all!
I will be starting an employed job making 200k and an independent contractor (IC) job also making 200k. So from the above discussion, would it be correct to say I do not have to pay any social security (ss) tax at the IC job as it will be covered by the ss tax I pay at the employed job?
Moreover, if what I stated is true and now if I use a corp at the IC job will what I stated no longer be the case as now the corp is considered a separate entity and will have to max out another 128k to cover another entities ss tax.
I think this was answered above to some degree, but just looking to solidify the answer if anyone knows and can help. I might have created a riddle so I can elaborate if needed haha.
Best,
TP
That’s right, unless you incorporate you won’t owe SS tax. If you do incorporate, you will pay both the employer and employee half again, but you will get back the employee half. The employer half will be lost without additional benefit to you. So probably not a good idea to incorporate.
Trying to understand the drawback here…
So, as a 1099 doc, you must pay self-employment tax, which includes both employer and employee portion of FICA tax. As a W2 doc, the employer portion is paid by your employer, but as 1099, since you are your own employer, then you are also paying that portion that you wouldn’t have to pay as a W2 employee?
So then, this paying extra SS tax only applies if you have both a W2 and 1099 separate jobs, correct?
Because if you have 2 1099 jobs, then you are just paying taxes on your combined income from both jobs, correct? I mean, if you have 2 1099 jobs that pay $100k each, vs just one 1099 job that pays $200k, then the total amount that you pay in taxes from both jobs should hypothetically be the same, correct? It only changes if you have 2 jobs where one is W2 and the other is 1099, right? what am i missing
That’s kind of right.
It works fine to have a W-2 and a sole proprietorship. You only get dinged once for the Social Security taxes. But if you have two W-2s (such as an employee job at the hospital and your own S Corp for moonlighting) then you can get back the extra employee Social Security taxes, but not the extra employer Social Security taxes you paid via the S Corp.
It also works fine to have “two 1099 jobs” whether the company is a sole proprietorship or an S Corp paying you wages.
Thanks for your response.
I understand about getting dinged once with SS taxes if you have a W2 job and a 1099 side gig. But why do you say that you also get dinged if you have 2 W2 jobs, because you pay the employer portion that you do not get back. I thought as a W2 employee, your employer paying you W2 salary pays the employer portion of SS tax. So you do not pay this tax as W2, your employer does. Am I missing something?
Well, technically you don’t pay it. But they may pay you less because they’re paying it on your behalf.
So the max amount of SS tax you have to pay is around 137k per year per entity.
If your 1099’s are taxed as an IC than the max you pay is 137k as both 1099’s are under the same IC entity.
But if you incorporate one of your 1099 jobs aka choosing to be taxed as an S corp, you have created a new entity and now have created an additional 137k of SS tax to pay.
Medicare, the other half of the FICA tax, from what I have read, has no limits so even one entity will always be charged the same percentage no matter how much money they make.
I am certainly not a tax attorney, but this is what I have gathered from a good amount of research and speaking about the subject with a few tax attorneys. Hope it helps.
You get back the employee half of the extra SS taxes you paid because of the S Corp but not the employer half. You pay Medicare on all earned income (but not S Corp distributions since they aren’t earned income.)
The wage limit in 2021 for SS taxes is $142,800.
BUT what if both your 1099 jobs are incorporated as an S corp? Then, you’really basically paying taxes on the combined income from both jobs, and only pay the self-employment taxes once. Is this correct?
If the 1099 jobs are both routed through one S-Corp, only one W-2.
No excess FICA tax since it is one payroll.
If two S Corps, then you’re getting dinged twice. Why not have one S Corp handle both jobs as two separate clients? Then you’d only pay once.
I am a physician fellow and trying to educate myself on these topics. I apologize for my low taxation/financial literacy and may not know enough right now to ask the correct questions, but I would like to start.
In three months I will start a partnership tract job and make a salary as an employee of 250000. Since I am an employee, I assume I will be getting a W2, and I will file taxes as I have normally done during my training. Am I correct to say that there would essentially be no tax benefit to forming all LLC, filing as an S-Corp before I make partner?
Once you are partner, the physician group is an LLC, but I have also noticed that some of the physician members are their own LLC within the group (which is why I started researching some of these topics).
The last few years, the compensation for a partner has been 500000-600000 dollars. Would the prudent thing to do be to form an LLC for myself, file as an S-corp, take the partner distribution and give myself a reasonable salary of say 250000-300000 with the rest as a distribution to lessen FICA, Self-employment or Social Security and Medicare taxes?
I am also now reading about the 199a deduction, and wondering if I would be able to utilize that break at some point.
That’s right.
Yes.
You probably won’t get a 199a deduction. You make too much and you’re a doc.
Am I allowed to file for an S corporation in any state (i.e. one I don’t live in or work in)? I ask because I read that it would be advantageous to file in Nevada or Delaware but I’d assume you can only do that if you live or work in those states?
I work in 3 different states as 1099 (MI, MO and IL with approx 80% of my 1099 income being earned in IL) and I live in MI. Thank you for the help,
Stephen B.
The asset protections and tax benefits of starting an LLC or S Corp in a state you don’t live or do business in is a bit overblown. Good discussion to have with your attorney and accountant, but I can tell you that WCI, LLC is a Utah LLC, not a Nevada, Delaware, or Wyoming LLC.
A few questions on Scorp:
1. Do we have to pay ourselves a Salary (on W2) if we sign up our PLLC to S Corp tax status?
2. Is there any tax savings if I do not pay myself any salary under W2?
3. Do you know of any reliable and affordable payroll service?
Do you have resources to reference if I want to do my own payroll. I assume there is paperwork to file with the state as well, right?
1. Almost surely.
2. Yes, but it probably won’t fly with the IRS. You have to pay yourself a reasonable salary.
3. Quickbooks will do it pretty easily, but that’s not someone else doing it, it’s you doing it with Quickbooks.
Yes, your state likely requires paperwork, but that’s not necessarily corporation specific.