Many owners/sole employees of small businesses set up S corporations on the advice of their tax advisers and compensate themselves with wages and profit distributions. Some of them pay themselves a low wage to save on employment (FICA) taxes and then get in trouble with the IRS because their wage is not “reasonable.” The end result is that they owe back taxes, penalties, and interest, and they will also have missed some important retirement contribution options. This item discusses how reporting a higher wage can actually maximize long-term profits for the owner-employee of an S corporation.
S Corporation Owner Compensation
If the owner of an S corporation provides services to the S corporation, part of the business income can be considered wages and the rest as a distribution. The range of wages earned by the owner-employee must be reasonable with regard to services rendered and must follow IRS guidance. However, there is discretion in determining a wage payment.
To illustrate the effects of different wages, this item compares the income from two S corporations. (A downloadable and interactive spreadsheet is available at http://ahwang.pageout.net; under the “Research” link, click on “Course Content,” then select “Taxation.”)
Example: A Corp. and B Corp. each earned $200,000 in income before wage and retirement contributions (IBWRC). Because the owners of both companies are also employees, each will earn a wage. Their companies will be able to deduct this wage as an expense and must pay FICA taxes. A is run by L, who pays himself a low salary of $15,500. H, the owner/employee of B, pays herself a high wage of $122,000.
Since L pays less in FICA taxes, it might be logical to assume that his tax burden would be less. However, if H is able to maximize her retirement contributions with a retirement plan such as a solo 401(k), her taxes will be surprisingly lower after future Social Security benefits are factored in.
The Advantages of a Solo 401(k)
Many options for retirement planning are available to the self-employed, such as profit-sharing plans, simplified employee pensions (SEPs), Keoghs, SIMPLE IRAs, and solo 401(k)s. A solo or self-employed 401(k) combines a profit-sharing plan with a 401(k) plan and allows a sole owner-employee to make greater tax-deferred contributions than would be permitted under the others.
The solo 401(k) has two components. First, it features an “employer” profit-sharing contribution component that allows the employer to contribute up to 25% of wages into a retirement fund, and it also reduces the business income by the same amount. Second, it has an “employee” elective wage deferral that allows the employee to make a contribution of up to $15,500 in 2008 or 100% of compensation (whichever is lower). While still subject to the FICA employment tax, the deferred wage escapes current federal income tax. The total for both components together is limited to $46,000 in 2008.
The maximum amount of total tax-deferred retirement contribution ($46,000 for 2008) is the same for a solo 401(k), a profit-sharing plan, a SEP, or a Keogh. However, with the advantage of the $15,500 employee wage deferral, available only to a solo 401(k), the S owner/employee can maximize the retirement contribution with a wage compensation of $122,000 ([$46,000 – $15,500] ÷ 25%). To contribute $46,000 to a retirement fund for those using a SEP, profit-sharing, or Keogh plan, the wage would need to be $184,000 ($46,000 ÷ 25%).
Since L earns only $15,500 from A, his personal FICA consists of Medicare taxes of $225 (1.45% of $15,500) plus Social Security taxes of $961 (6.2% of $15,500), for a total of $1,186. A also pays the same amount of FICA taxes; however, this is a tax-deductible expense for the company.
The calculations for H are markedly different. With an income of $122,000, H would pay Medicare taxes of $1,769 (1.45% of $122,000) plus Social Security taxes of $6,324 (6.2% of $102,000, the maximum wage subject to Social Security taxes in 2008), for a total of $8,093. H’s company would pay a like amount, and this expense would also be tax deductible.
Taxable Income After Retirement Contribution
Even though both companies have earned $200,000 (IBWRC), factoring in retirement contributions produces some real differences in L’s and H’s taxable income if both taxpayers have a solo 401(k) plan in place and maximize their tax-deferred contributions. With $15,500 in wages, L can contribute only $3,875 (25% of $15,500) for the employer portion of his solo 401(k) and $15,500 for the employee component if he wishes to maximize his retirement contributions. Beginning with the $200,000 S corporation income, less the $15,500 “employee” contribution and the $3,875 “employer” contribution to his solo 401(k) retirement, less the tax-deductible portion of FICA taxes paid by the S corporation ($1,186), A has a profit of $179,439 to be distributed to L. Because L elects to defer 100% of his $15,500 wage to his retirement contribution, he now has a total taxable income of $179,439.
H, on the other hand, can put far more into retirement and therefore has lower taxable income. H’s employee contribution would be the same as L’s, $15,500. If she wishes to maximize her employer contribution, she would be able to contribute as much as $30,500 (25% of $122,000). These amounts added together equal the $46,000 limit for 2008. Thus, the $200,000 S corporation income results in a distribution of $39,407 after wages ($122,000), employer retirement contributions ($30,500), and FICA taxes ($8,093) are subtracted. Her wages of $122,000 less the employee contribution of $15,500 results in $106,500. H’s total taxable income is $145,907 ($106,500 + $39,407).
Effective Tax Rate Before FICA Taxes
Since L and H have significantly different taxable incomes, it is no surprise that their tax burdens will be different. Based on his $179,439 taxable income, L would owe $48,591 in personal income taxes before FICA taxes are calculated if he files as married filing separately. This represents an effective tax rate of 27.08% ($48,591 ÷ $179,439). This rate is important in calculating his total taxes, to be illustrated later.
With a taxable income of $145,907, H’s personal income taxes are $37,514 before FICA. The effective tax rate here is 25.71% ($37,514 ÷ $145,907), based on the schedule for married filing separately.
Calculation of Tax Burden
Given the effective tax rate computed above, the total taxes due on each individual’s taxable income can be calculated. With an effective tax rate of 27.08%, L’s wage of $15,500 would result in taxes of $4,197 (27.08% × $15,500) if he were not contributing to his retirement plan.
The next factor is FICA taxes, which are paid by both the employee and the employer. The portion of FICA paid by the employer, however, is a tax-deductible business expense to the S corporation and results in a tax saving. L pays FICA of $1,186, as shown above. The S corporation pays the same amount and enjoys a tax deduction of $321 (27.08% × $1,186). The outcome is net FICA taxes of $2,051 ($1,186 × 2 – $321).
The taxes on L’s profit distribution of $179,439 are $48,592 (27.08% × $179,439). In summary, L has $50,643 total tax due, which includes $4,197 on the $15,500 wage, plus $2,051 for the net FICA tax, less a tax saving of $4,197 due to the contribution of his entire wage to retirement, plus $48,592 taxes on the $179,439 profit distribution.
Even with a much higher wage of $122,000, H pays a total tax of $51,619. The amount is only $976 higher than the $50,643 taxes to be paid by L. While H pays higher FICA taxes, she is able to reduce her total tax bill by taking full advantage of the tax savings on her retirement contribution. In addition, she has paid substantially more into her Social Security. Once the benefit to be received from Social Security contribution is considered, H’s tax burden will be substantially less than L’s.
Consideration of Social Security Benefits
Although the taxpayer will not be able to access Social Security benefits immediately, they can be a significant source of income in retirement. A precise calculation of Social Security benefits is beyond the scope of this item. Historically, however, researchers have found that individuals receive greater lifetime returns than they paid in Social Security taxes. (See, e.g., Leimer, “A Guide to Social Security Money’s Worth Issues,” 58 Social Security Bulletin, No. 2 (1995): 3–20.) For the purposes of this item, assume that L’s and H’s Social Security benefits will equal their actual contributions.
L pays $50,643 in taxes, resulting in a tax rate of 25.32% ($50,643 ÷ $200,000). Only $1,922 of his FICA taxes go to Social Security (both he and his S corporation pay $961). If the Social Security benefit is subtracted from taxes paid, L’s true tax is $48,721. Essentially, the tax rate is 24.36% ($48,721 ÷ $200,000).
Because H earned a wage of $122,000, her calculations are much different. She will pay $51,619 in taxes for a 25.81% rate ($51,619 ÷ $200,000). Of this amount, $12,648 will be contributed to her Social Security (both she and her S corporation pay $6,324). In this instance, if her Social Security benefit is subtracted from the taxes, H has a much lower tax in the amount of $38,971. This represents 19.49% of her income before wages and retirement contribution ($38,971 ÷ $200,000).
These calculations illustrate that reporting a low wage is not advantageous. L, an S corporation owner who is also an employee providing service to the business, may think that taking a small wage reduces his FICA taxes and hence maximizes his income. However, with a low wage, he loses the tax savings opportunities on his retirement contribution, increases his effective tax rate on the profit distribution, and eventually pays taxes similar to the amount paid by H. In addition, L would further miss earnings opportunities by forgoing tax-deferred retirement contributions.
H, who pays herself a higher wage, is able to defer her taxes by making the maximum retirement contribution. While paying higher FICA taxes due to her higher wage, H is able to more fully fund her Social Security. This results in not only a lower tax rate when the Social Security benefit is factored in, but perhaps also a more comfortable retirement.
Lorin D. Luchs, Partner, Washington National Tax Office BDO Seidman, LLP, Bethesda, MD.
Unless otherwise indicated, contributors are members of or associated with BDO Seidman, LLP.
If you would like additional information about these items, contact Mr. Luchs at (301) 634-0250 or firstname.lastname@example.org.