Originally published on Forbes.com Aug 25th, 2013
Even though Sean P. McAlary lost in Tax Court, the decision in his case shows that S Corporations are still a valid self-employment tax avoidance strategy. If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax. If you put the business into an S Corporation, none of the income will be subject to self-employment tax. Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.
The Exposure
There is a catch. In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends. With S Corporations, the Service may take the position that corporate distributions are actually disguised salary. That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff. When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea. I mean, nothing ventured, nothing gained. What is nasty is the $6,000 or so in penalties.
Win, Loss or Draw ?
So would Mr. McAlary have been better off for 2006 if he had run his business as a proprietorship and paid self-employment tax on the entire profit. Forgive me for not doing the precise computation, but it is actually close to a push. Mr. McAlary had his corporation pay him no salary at all. There was an agreement in place for his salary to be $24,000. The IRS expert argued that his salary should have been $100,755.
The Tax Court determined that $83,200 was actually the right number. According to the discussion in the case the net income of the S Corporation was $231,454 and the total on page 2 of his Schedule E was $200,877. His distributions from the S corporation were $240,000. I can’t tell why there is a difference. Perhaps he or his wife has another S Corporation that lost money. Regardless, by running as an S Corporation, he avoided the effect of Self-employment tax on between roughly $120,000 and $150,000 of income, even after getting audited.
That nasty $6,000 in penalties probably puts him a bit behind particularly when you throw in the tsoris of going all the way to Tax Court. Mr. McAlary represented himself, though, and did win a small concession, so you can’t rule out that he may have enjoyed the fight. When you consider other years, where he did not get audited, he came out way ahead using the strategy.
How To Win Almost For Sure ?
Explaining things like this throws me back to the early days of my career. My elaborate analysis would need to be translated into terms that the client would understand. After absorbing as much of the analysis as he thought relevant, Herb Cohan would then say to the client – “Don’t be a chazzer !” The more elaborate version of that caution on the limits of aggressiveness in tax planning was “Pigs get fed. Hogs get slaughtered.”.
What the McAlary case teaches us is not that you can’t use an S Corporation to avoid SE/payroll taxes. It teaches us that you really should not use the strategy to avoid SE/payroll taxes entirely.
The case also shows us where to go for guidance. The IRS expert cited Risk Management Association Annual Statement Studies. RMA, as we used to call it, is a great reference tool. I used to use it a lot, before I became overspecialized. It provides averages of financial statements submitted to banks by businesses applying for loans and the like.
Apparently being an expert for the IRS on reasonable compensation is not exactly rocket science. You can do it for yourself and come up with a reasonable percentage of profit to take as salary. There is actually a wealth of other potentially useful data in RMA which might give you a sense of how well you are doing on things like inventory turnover and collections.
Don’t Be A Chazzer
The AICPA standards of tax practice prohibit me from giving clients audit lottery type advice, but you and I are just pals, so I think I am in ethical bounds when I tell you this.
If your business is reasonably profitable, don’t even think about taking less than whatever the unemployment wage base is in your state is. That varies substantially by state ranging from $7,000 in Arizona to $39,800 in Washington. By going below that limit you end up with another group of enforcers being interested in you. My limited experience with them is that they are very stubborn and since there are not many dollars at stake the temptation will be to just pay it. There is then the potential that they will rat you out to the IRS.
If your business is quite profitable, be a sport and take something over the FICA maximum. The savings can still be quite substantial. Newt Ginrgrich took about $250,000 in salary with profits over $2,500,000 in his S corporation. That got him some bad press, of course, but you are probably not going to be running for President. It is worth noting that the President, himself, did not play this particular game and paid SE tax on all the net income from his book royalties.
Policy Question
With the new Obamacare Net Investment Income Tax, almost all income that individuals get from businesses is potentially subject to a Medicare levy of one sort or the other. An exception is business flow-through income from businesses in which the taxpayer materially participates. Were it not for that exception, the Obamacare tax would have taken the fun out of the S Corp SE game for fellows like Newt Gingrich. I worked briefly (17 months) for a national firm and got to rub elbows a bit with one of the national guys who would talk to congressional staffers. I asked him if there was any policy justification for this odd loophole and he knew of none.
Is The Game Worth The Candle ?
If you convert a proprietorship to an S Corporation, there are some costs to weigh. If you are going to take salary below the FICA max, there may be an effect on future social security benefits. Actually quantifying that is challenging, but you can give it a shot with some of the calculator programs. I have never gone through that exercise and my experience is that most business owners are dismissive of it. So you can take that factor as a “just saying” if you want.
Operating as an S Corporation will require another tax return to be filed, which might cost something. In principle, your individual return should be somewhat easier, since a Schedule C is no longer required. You may need to “remind” your tax preparer of that in order to realize that saving on the individual return that might offset some of the cost of the S Corporation return.
If you are a brown paper bag type of client with a masochistic CPA, the realization on doing your return might be so lousy that even without your Schedule C, standard charges might come out higher than what you paid in the previous year. On the other hand if you are a mensch with a CPA who “knows how to bill” your fee will never go down from one year to the next if you don’t ask.
Although there is a good chance that the potential for your individual return being audited will go down, the S Corporation return will be another return that potentially could be audited. I don’t know how that balances out and I suspect that nobody knows, although you will find plenty of people who will tell you they know.
If your business involves significant debt and has irregular income, there are a lot of tax traps in operating as an S Corporation. It gets really complicated if you have multiple businesses and real estate ownership is somehow involved. If you are the type of person inclined to pay the bills out of whatever account happens to have sufficient cash and let your accountant sort it out with journal entries, you may be setting yourself up for an income tax nightmare in your quest to save a few thousand dollars in SE tax.
I have known partners in professional practices who contributed their partnership interests into S Corporations and encouraged me to do the same. I never regretted not doing it and they came to regret having done it, except the one who died. I’m pretty sure his executor really regretted it.
Finally, don’t ignore state and local income taxes in planning this move. There can be pluses and minuses depending on which state or states you are dealing with. New Hampshire is a particularly nasty place to fool with S Corporations and don’t get me started on New York City. Regardless, you need to consider state and local taxes carefully, particularly since you are not really saving a very high percentage federally from making this move.
Conclusion
Despite court losses and the lack of any discernible policy justification, it appears that the S Corporation SE tax avoidance strategy is still solid. Small business owners should examine the implication carefully, though, before jumping into it.
You can follow me on twitter @peterreillycpa.
Afternote
If you are in the Northeast and really want to nail down a strategy on this you might want to consider taking one of the Boston Tax Institute courses taught by Lucien Gauthier. Lu provides the right mix of in-depth technical coverage and practical reality. (Full disclosure: I taught a course for BTI about a million years ago.)
S Corporation SE Avoidance Still A Solid Strategy
