I have been advising owners of C Corps, S Corps, and LLCs, among others, for years and feel I can wade in on this.
Part of the issue here is political, with the government wanting to enlarge its tax-revenue base and with small business owners wanting to minimize taxes they pay.
Another part of the issue deals with the fairness of taxing pass-through entities such as S Corps and LLCs for employment taxes. Remember that such entities can consist of owners who are employees and also of owners who are not. When such entities make profits on their operations, they can keep the profits in the company to fund growth, they can distribute all profits to their owners, or they can keep part of the profits in the company and distribute the rest to owners. Whether the profits are distributed or not, they are treated as net income of the entity and are "passed through" for tax purposes to the owners of the entity, who in turn must each report their allocable share of such profits as a line item on their individual income tax returns and pay income tax on them accordingly. This is true of both employee owners and non-employee owners.
The idea behind a pass-through entity is that owners can escape the burden of a double tax that would otherwise apply on profits were such profits to be taxed once at the entity level and then again on their distributions to owners of the entity as dividends. This idea derives from old-style partnership law, which has always taxed partnerships in pass-through fashion, in contrast to corporate law, which has always taxed C corporations at the entity level and then again whenever dividends were declared and paid to shareholders.
The pass-through idea is good and bad for S Corp shareholders and LLC members. It means that income tax issues are much simplified and income taxes minimized. Since the imputation of profits to owners is automatic, whether or not profits are actually paid out to such owners, it also means that owners can incur phantom income, and have to pay tax on it, if profits are not actually paid out.
When it comes to employment taxes, however, the issue becomes more complicated.
The broad idea behind employment taxes is that anyone who earns wages or salary as an employee or who makes profits while working a business directly as a proprietor is required to pay into Social Security, Medicare, etc.
Current tax law penalizes LLCs in this respect because it imposes employment taxes on all owners of the business, whether they are employees of the business or not. In other words, it simply presumes that anyone who would set up an LLC would do so to work in it directly and, thus, should be required to pay employment taxes on any profits from that business.
The rule with S Corps is actually fairer in this respect. With an S Corp, owners employed by the business are required by law to pay themselves "reasonable" salaries for services rendered to the business. Those salaries are then taxed to such individuals directly as employment income and the individuals who receive them pay both income tax and employment taxes on the amounts received as salary. Any profits that are passed through to shareholders other than as salary/wages, however, are not subject to employment taxes. This means that non-employee owners of an S Corp will pay income taxes on their pass-through income but not employment taxes. It also means that employee-owners will pay both income tax and employment tax on their salaries but will pay no employment tax on amounts earned in excess of their salaries.
The gist of this article is to suggest that S Corp owners have systematically abused their position by understating the salaries they pay to themselves and using this as a way of avoiding employment taxes on their true income. The corrective, it is assumed, would be to subject all S Corp income to employment taxes as well as income taxes.
There is clearly an unfair disparity between the way S Corps and LLCs are taxed in this respect. However, it is not necessarily more fair to subject all S Corp income to employment taxes. Such a change would impose employment taxes on all non-employee owners of an S Corp and make them pay things such as Social Security tax on income that for them is purely investment income.
The problem here is an audit problem, given that the S Corp rules already use a theoretically fair system for deciding which aspect of a company's profits is fairly allocable to "employment" as opposed to "ownership."
How that problem is corrected, then, turns into a political issue. For those favoring the government's broad ability to tax away, it means closing a loophole. For those favoring the ability of small businesses to pay fair employment taxes tied to actual employment activity by owners, the current system is fine.
While it might be argued that the current system is abused, and hence that the current S Corp rules should be changed, a similar argument might be made about under-reporting of income by small businesses generally. The question is, because some cheat, should all be penalized? I tend to think not but, as I said, this becomes as much a political issue as anything else at this stage, and not a legal one. People will differ on the best resolution.
So if a startup is generating $4k a month, is it assumed for tax purposes that all of it is paid to the owner with no money left to grow the business? Or is there a better formula such as MAX(fair salary, 50% of business profits) ?
If a tax-pass-through entity wants to retain net profits for business growth, its several owners still have to pay income tax on those profits in the year they are earned, regardless of whether they are distributed to the owners. This is an inherent limitation with this sort of entity, as it does not easily lend itself to a profitable venture that keeps sucking up cash to fuel growth. Unfortunately for the individual owners in such an entity, the net income is imputed to them as earned and the only way they can normally avoid "phantom income" problems in such situations is to convert to a C corp.
Of course, this applies only with respect to actual profits. If your startup is generating revenues, and such revenues are spent on growth in ways that generate deductible business expenses as you go, the only part that is potentially taxable is the net amount earned after expenses. The revenues in such a case can be used to grow a business without creating any particular tax problems for the owners.
The problem is actually the opposite, that S-Corp is not a scam but LLC is a tax hawk. If your bootstrapped startup ever becomes profitability, you will learn quickly that taxation (with or without representation) is your number one cost (more than labor, more than sales and marketing). First you pay 15.3% self-employment tax, then 35% Federal tax, then 9.3% State tax (if you live in California) and finally 9.25% sales tax (if you live the Bay Area), that's 69% tax before net profit (necessary for rainy days). As my good friend Art once told me, everyone eventually becomes a "conservative", you just have to have something to "conserve" first. I immediately became a conservative when I saw profit and I believe you will too. If you want to avoid double-taxation (i.e., first tax as an individual, then as a Corporation), then you have two choices. You can form an LLC or you can form a S-Corp. The advantage of LLC is that there is a lot less legal overhead and there is no restriction with foreign ownership (this is a big deal if you happen to have a co-Founder who is not a US resident or citizen or if you have partners overseas). The problem with LLC is that ALL of your profits are taxed as self-employment income (15.3% off the top). On the other hand, with S-Corp, you do need to pay yourself a market-value salary (or you will be subject to audit so it is never a scam as some commenters would suggest). In my own experience, the optimal solution turns out to be that of forming your startup as an LLC but file a S-Corp (form 1120S). The following is a good read.
They're not talking about "wringing more money out of the country's small businesses". They're shutting down a huge scam.
Sole proprietors, LLC owners, and partnership members pay self-employment tax, which replaces the employee and the employer's share of FICA.
Every employee in the nation pays FICA, whether they work at Starbucks or Goldman Sachs.
S-Corp owners elude this tax --- which everyone else has to pay --- by claiming unnaturally low salaries. Only the salary is eligible for self-employment tax. The remainder of the S-Corp owner's comp is disbursed directly as a distribution (think "profit-sharing"), and is for no good reason exempt from self-employment tax.
Whatever you may think of Social Security (Forbes: clearly not a fan), it is unfair that a shift manager at Starbucks should have to pay a tax that a 6-figure-income small business owner gets to walk away from.
I say this as the co-owner of a profitable small business.
Keep in mind that S-corp owners (full disclosure: I am one) pay not just the employee's side, but also the employer's side, of FICA -- so what's 7.5-ish percent of payroll to a typical employee is actually 15-ish percent to a small business owner.
Also, if you happen to be contributing to a SEP IRA, or concerned about the size of your eventual Social Security distribution (which is based on your 40 best payroll quarters), then you as an S-corp owner also have an interest in running a higher amount as payroll rather than profit. It's a balancing act with multiple factors, as with most tax considerations. Add in month-to-month cash flow uncertainty, and "reasonable" becomes very elastic very quickly.
Pure speculation, but I'd wager that the amount of tax avoided by small business owners by underpaying salaries is likely dwarfed by those avoided by the owners of bigger companies, who have the combined benefits of lobby power and armies of accountants figuring out loopholes for them. But maybe I'm just cynical and getting old.
Those loopholes should be closed too. I just don't see an intellectually honest argument that concludes that an $80,000 "bonus" over a $10,000 salary is somehow, through the magic of small business, less taxable than a $90,000 salary.
Also: I'm wading into deep water by saying this, but the issue isn't income uncertainty at all, is it? It's not how much you make, it's how much you list as payroll-taxable income. Sure, your salary may be uncertain over the year, but if you end up at $90,000 from your company, your whole income should be liable for FICA just like a BigCo worker's.
"if you end up at $90,000 from your company, your whole income should be liable for FICA just like a BigCo worker's"
Why? By that reasoning, shouldn't profits that BigCo shareholders make (which become personal income when they realize them) subject to FICA? I'm both an owner and an employee -- why shouldn't some of my income be FICA-taxable as the output of "labor", and some be non-FICA-taxable as business profit?
>Shrug<. The profits that private traders make are technically investment income too, but they have to pay self-employment on them.
I think the reality is that most of the income we're talking about here really is just the product of labor. I'd be interested in hearing the scenario in which a small S-Corp is generating profits that are meaningfully different from their basic payroll.
S-Corp will pay payroll taxes on "fair salary" even if none of the profits are distributed and all of it is reinvested back into the business. That's unfair too, isn't it? And it's very typical for a bootstrapped company - I keep burning through my savings and reinvest all company profits back into the business. Why should I pay payroll taxes on that? That money was never paid out to anyone and shouldn't be taxed as anything more than income tax.
Deciding how to balance expenses in a small corp is not a "huge scam" If it were so, then what would be the "honest" solution? Having the government tell S-Corp owners what they should have paid themselves (and therefore what FICA they owe)? Having a standard FICA bill that "fairly" everyone would owe?
The more you over-complicate the system, the more things are going to happen that you personally think of as a "scam". Is a realistic solution to complicate the system further?
Put me on the side of small business owners being able to allocate payroll expenses as they see fit, and not on the side of arbitrary fees and fines to make everybody else happier, whether that's for healthcare or FICA.
If we should be able to "allocate payroll expenses the way we see fit", then I'm going to "allocate" 100% of my taxes back to my bank account. Funny how that works!
You've missed half the issue. These aren't people taking a $10,000 salary so they can grow their business. They're taking a $10,000 salary and a $80,000 distribution (self-employment tax is capped) and paying taxes only on the $10,000.
If you do that, then it's income and you'll pay income tax, as you know.
You can't get something for nothing. S-Corp profits pass through, so they hit you as income tax, not payroll tax. It's the same situation as a guy who sells apples suddenly selling a truckload of them -- it's income.
Whining about how people "should" have done this or "should" have done that is all so much noise. What do you want? A forced payroll system?
I'm now unconvinced that you know what payroll tax is, or how S-Corps work. One of the reasons you file as an S-Corp is to W2 your income. Owners of S-Corps pay W2 like everyone else.
This isn't some system where by design we designate S-Corp income as "income" and thus "exempt from payroll tax" (payroll tax being, for the most part, FICA). If it was, LLC income --- which is, for owners, entirely distributions --- wouldn't be liable for self-employment tax.
This is a situation where very specifically the S-Corp designation allows people to create a channel to avoid paying FICA tax that they owe.
If you have $90,000 of income and you're a small business owner, you should be paying your share whether the income is salary or distribution.
You can call it "whining" and "noise" but since this practice was already an audit flag I have very little to whine about; my side of the argument already won. All I'm saying is, "good for them for closing this loophole".
[Edit: you clearly do know how S-Corps work, so now I'm wondering why you're playing semantic games with the word "income".]
I've owned an S-Corp for 15 years, I think I would know how one works.
Do you or have you ever ran an S-Corp? You seem to be providing a lot of opinions. Just wondering what your credentials were.
Owners of S-Corps pay off a W-2 for that portion of their income paid as payroll. The rest of it comes across on a different schedule (1120-S). I've been doing this for years. I think I know.
All business arrangements have the option of how to handle excess income. Some entities may pay every penny of it to founders as W-2 income. Some may choose to pay a bit and hold the rest as savings. Some may create a bonus situation, LLCs have direct disbursements, etc.
For sole proprietors and S-Corp owners, excess income (income not spent in payroll or other "legit" expenses) "flows down" to the owner, which has to pay the rest as income tax.
It's not specific to S-Corps at all. The "scam", as you put it, could be as simple as the decision to hang on to some cash in the corporate account at the end of the year instead of paying payroll, or it could be the decision to use a bonus-as-disbursement system. Either one would be bypassing FICA.
Or you could decide you'd rather not take a payroll for yourself. Perhaps your income is spotty, you can't afford to pay yourself minimum wage, or perhaps you can't deal with the overhead required for payrolls. Whatever. It's your decision.
I'm going to bail out now -- I've played the infinite argument game with you before. I'm happy to admit fault if I don't understand this -- but I'd be really, really, really surprised if that was the case.
And congrats on ducking the question I asked about solutions and instead turning the conversation to my qualifications. Makes it much less a conversation and much more a debating game.
(You annoy me, but I think your comment is mostly in good faith [I'm pretty sure you'd rather not come out and make the honest argument, which is that you think everyone should be able to opt out of Social Security]. I voted your comment back up to "1".)
No, that is not my position and I do not support that position.
Please do everyone a favor and try to advance the discussion instead of trying to stick your opponent in some kind of rhetorical box. I asked three questions and spent all of my bandwidth addressing your attacks on me personally instead of trying to understand/advance the discussion. The only reason I tried to talk to you was to find out what your proposed solution was. Instead I'm dancing around with you trying to justify my right to speak on the matter. That's really messed up. I don't mind getting trashed, but surely we all have better things to do here. The purpose of the board is to explain and advance issues, not score cheap points and "win" debates. It's really getting old.
For the record, here are the questions I had that I never got answered:
what would be the "honest" solution?Is a realistic solution to complicate the system further?What do you want? A forced payroll system?
The BEA collects tons of statistics on compensation by geography and vertical. If you file with a salary far below the norm for your role, location, and industry, and then take a distribution that brings your compensation above that norm, you should be audited.
That's roughly the current situation --- except that instead of codifying some reasonable standard reference for wages, it's up to a court to decide, which is not what an owner wants. I'm not advocating a Wage Panel.
You're don't appear to be arguing about process. You're arguing against the very idea of recovering payroll taxes from business owners who have deliberately filed with artificially low salaries so they can avoid paying FICA is arbitrary. I'm saying, what seems arbitrary to me is the fact that simply by organizing their business superficially differently, consultants can skip out on taxes that normal wage earners have to pay.
I don't know much about S-Corps, but don't they just spend excess revenue on stock buyback while giving $1 a year (Steve Jobs style) employees generous stock options taxed at 15% capital gains tax?
Is there a law that prevents the company from doing stock repurchases from private owners though?
If the private stock owners always agree to sell the stock back to the company at a higher purchase price (achievable with a handful of private owners), then there would be no liquidity problem.
Say you're the sole shareholder of an S-Corp which, not including your salary, has $200,000 in the bank on Dec. 31. You have two ways to put that money in your pocket: either a) pay yourself a salary as an employee (say, $75,000) plus the remaining $125,000 as corporate profits, or b) just give yourself, as the sole shareholder, all $200,000 as corporate profits.
With option b), significantly less money will end up in Uncle Sam's pocket. I happen to agree with you that that's a good thing, but the fact remains that the IRS considers it tax evasion. So not a good thing to engage in. S-Corp owner/employees have to pay themselves what the government agrees is a reasonable market wage before they can start banking relatively lightly taxed corporate profits.
A counter argument is the possible disparity between hours worked and income. If I build an iphone app in a month, and it makes me 80k suggesting all of that is salary is a mistake. At the other end spending 600 hours building an app that nobody buys should not require paying SS taxes on the minimum wage * hours worked.
Edit: A professional gambler pays SS taxes, a lotto winner does not.
The risk profile of different markets are not all the same. Bill Gales made silly amounts of money by having great connections, getting lucky, and executing ruthlessly not just working hard. A contractor can leverage capital and risk to make money, where the average consultant only risks his time (which can still be worth a lot). This would not be important except we tax different types of earnings in a different manor. We don't ask a retired auto worker to pay SS taxes on his pension.
Now, as a rule a single employee company is probably a glorified employee working for someone else, but there are a huge number of exceptions to this general rue. For example someone who manage real estate is more like an active investor and the tax code should probably treat them as an investor rater than a working stiff who happens to make whatever they happen to make.
Also because people are involved in the loop, an auditor can probably tell what is going on will minor issues. If you are subletting your basement after the kids graduate from collage != managing a burger king != owning a burger king.
That depends on how active they are. Day traders owe self-employment tax, passive investors don't. Plenty of people are somewhere between those extremes.
My only point is that payroll taxes aren't really a risk-based standard. Small business owners do take on different risks than employees, but they're compensated by long term returns, not by tax breaks.
It's not a question of risk, but what you risk and what you gained from the risk. My point is when you earn above market rates it's often because of risk to capital not effort. If what's making money is Work you pay SS if it's Capital you don't. If it's a combination of both you first need to pay SS / Medicare on a reasonable wage for what you are doing, but the extra earnings from Capital * Risk don't require SS / Medicare payments.
Under the current system, building an iPhone App is really two things taking a risk with some capital and building the App. If you work for a year and it makes 120k then you pay taxes as if you worked a normal job. If you make zero you pay taxes as if it was a hobby.* If you make 10 million, you pay taxes as if you had a normal job that made ~140k AND made 9,840k from an investment.
This is reasonable because when you earn a normal salary from your work your risk had zero return so you pay zero taxes on the risk. If anything it's when you earn less than market rates when it gets tricky.
*(I don't know what the actual tax ramifications of this are. If you do major home remodeling while unemployed you are not supposed to be able to collect unemployment even though you don't have a direct cash reward. In theory you might be required to pay taxes on the work you did.)
Part of the issue here is political, with the government wanting to enlarge its tax-revenue base and with small business owners wanting to minimize taxes they pay.
Another part of the issue deals with the fairness of taxing pass-through entities such as S Corps and LLCs for employment taxes. Remember that such entities can consist of owners who are employees and also of owners who are not. When such entities make profits on their operations, they can keep the profits in the company to fund growth, they can distribute all profits to their owners, or they can keep part of the profits in the company and distribute the rest to owners. Whether the profits are distributed or not, they are treated as net income of the entity and are "passed through" for tax purposes to the owners of the entity, who in turn must each report their allocable share of such profits as a line item on their individual income tax returns and pay income tax on them accordingly. This is true of both employee owners and non-employee owners.
The idea behind a pass-through entity is that owners can escape the burden of a double tax that would otherwise apply on profits were such profits to be taxed once at the entity level and then again on their distributions to owners of the entity as dividends. This idea derives from old-style partnership law, which has always taxed partnerships in pass-through fashion, in contrast to corporate law, which has always taxed C corporations at the entity level and then again whenever dividends were declared and paid to shareholders.
The pass-through idea is good and bad for S Corp shareholders and LLC members. It means that income tax issues are much simplified and income taxes minimized. Since the imputation of profits to owners is automatic, whether or not profits are actually paid out to such owners, it also means that owners can incur phantom income, and have to pay tax on it, if profits are not actually paid out.
When it comes to employment taxes, however, the issue becomes more complicated.
The broad idea behind employment taxes is that anyone who earns wages or salary as an employee or who makes profits while working a business directly as a proprietor is required to pay into Social Security, Medicare, etc.
Current tax law penalizes LLCs in this respect because it imposes employment taxes on all owners of the business, whether they are employees of the business or not. In other words, it simply presumes that anyone who would set up an LLC would do so to work in it directly and, thus, should be required to pay employment taxes on any profits from that business.
The rule with S Corps is actually fairer in this respect. With an S Corp, owners employed by the business are required by law to pay themselves "reasonable" salaries for services rendered to the business. Those salaries are then taxed to such individuals directly as employment income and the individuals who receive them pay both income tax and employment taxes on the amounts received as salary. Any profits that are passed through to shareholders other than as salary/wages, however, are not subject to employment taxes. This means that non-employee owners of an S Corp will pay income taxes on their pass-through income but not employment taxes. It also means that employee-owners will pay both income tax and employment tax on their salaries but will pay no employment tax on amounts earned in excess of their salaries.
The gist of this article is to suggest that S Corp owners have systematically abused their position by understating the salaries they pay to themselves and using this as a way of avoiding employment taxes on their true income. The corrective, it is assumed, would be to subject all S Corp income to employment taxes as well as income taxes.
There is clearly an unfair disparity between the way S Corps and LLCs are taxed in this respect. However, it is not necessarily more fair to subject all S Corp income to employment taxes. Such a change would impose employment taxes on all non-employee owners of an S Corp and make them pay things such as Social Security tax on income that for them is purely investment income.
The problem here is an audit problem, given that the S Corp rules already use a theoretically fair system for deciding which aspect of a company's profits is fairly allocable to "employment" as opposed to "ownership."
How that problem is corrected, then, turns into a political issue. For those favoring the government's broad ability to tax away, it means closing a loophole. For those favoring the ability of small businesses to pay fair employment taxes tied to actual employment activity by owners, the current system is fine.
While it might be argued that the current system is abused, and hence that the current S Corp rules should be changed, a similar argument might be made about under-reporting of income by small businesses generally. The question is, because some cheat, should all be penalized? I tend to think not but, as I said, this becomes as much a political issue as anything else at this stage, and not a legal one. People will differ on the best resolution.