Self-employment tax for tax year 2021 is 15.3% and is comprised of two components, social security (12.4%) and Medicare (2.9%). In short, the IRC (Internal Revenue Code) essentially deems all payments made to shareholders of an S corporation as wages that are subject to employment tax. However, the caveat, is if a shareholder is paid a reasonable salary for the services they perform from the S-corporation, then distributions paid above and beyond the salary can be classified as non-wage distributions and thus not be subject to employment tax. For comparison purposes, partnership distributions do not get the same benefit. All earnings are subject to employment tax up to applicable phase out limitations. So, does this mean that an S-corporation is the perfect fit for every business owner and will save every business owner a bunch is taxes every year? We do wish it was that easy, but unfortunately, we haven’t looked at the bad.
1. Administrative costs of an S-Corp
As we pointed out, an S-corp. shareholder needs to pay themselves a reasonable compensation before receiving the benefit of having profits distributed that are not subject to employment tax. This means that a shareholder will be receiving a W2 salary, and if so, withholdings monthly are common. This will result in quarterly payroll tax filings and W2’s to be completed on an annual basis. A small detail that is often overlooked.
2. Lack of flexibility
Unlike an LLC that is taxed as a partnership, S-corporations are rigid structures. For example, S-corporation profits are required to be distributed based on ownership and prevent partners from participating in profit sharing structures that don’t necessarily align with ownership percentages. This can be problematic for partnerships that distribute earnings based on certain performance metrics that fluctuate year over year.
3. Passive Income Limitations
S-corporations are great options for shareholders that materially participate in a business, however, if more than 25% of the earnings of an S-corp. are generated by passive activity, any passive earnings above the 25% threshold are taxed at a higher rate. Furthermore, if an S-corp. is consistently reporting passive income greater than the 25% threshold, the IRS will revoke the entity’s S-election, which can be very problematic and result in steep tax increases depending on the type of structure the entity reverts to.
At the end of the day, making an S-election can be the perfect fit, or it can be a huge mistake that becomes very costly. We strongly recommend consulting with a CPA or tax adviser to discuss your specific situation prior to making an S-election.
*This article is meant to be informative and should not be relied upon as tax advice.