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.
The Basics of Incorporation
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. 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.
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 Me 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 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:
What do you think? Are you an S Corp? Why or why not? Comment below!