Converting to an S Corporation to Reduce Self-Employment Tax
If, after deducting all of your business expenses, you still have more than $60,000 of net business income, making an election for you current business entity (e.g., partnership, LLC, etc.) to be federally taxed as an S Corporation will save you thousands in taxes. The cost-benefit ratio of engaging our firm to handle the process will be immediate since retroactive S corporation elections are permissible.
The most common inquiry we receive from high-earning self-employed individuals is whether they could save money converting to an S Corporation. The answer is most definitely yes. Allow us to explain.
Everyone has to pay social security and Medicare taxes on their wages. The social security tax rate is 6.2%, and the Medicare tax rate is 1.45%. Together, these taxes, which are mandated by the Federal Insurance Contributions Act (FICA) is 7.65%. For tax year 2019, the full FICA tax only applies to the first $132,900 of wages. For all wages above $132,900, there is an additional 1.45% Medicare tax. And for all wages above $200,000, there is an additional 0.9% Medicare tax on top of the 1.45% mentioned before.
However, what many people do not know is that your employer has to make a matching contribution of the same 7.65% on the first $132,900 of wages. Together, a total of 15.3% tax is saved toward your retirement for a social security retirement pension as well as Medicare health benefits. This is how those societal programs are funded.
The problem for self-employed individuals is that you are both the employee as well as the employer, so you’re on the hook for the full 15.3%, which is what the self-employment tax is.
S Corporations are governed by only fourteen Internal Revenue Code sections; 1361-1379. Under Section 1366(a), the pass through of tax items is limited to tax under Chapter 1 of the Code, which are normal income taxes. Self-employment tax, however, falls under Chapter 2. Furthermore, under Chapter 2, Section 1402 specifically provides that the income of a partnership is subject to self-employment tax; however, that has not been extended to S corporation shareholders. This led many tax practitioners to conclude in the 1980s that pass-through income from an S corporation was not subject to the self-employment tax.
In 1983, the U.S. Tax Court specifically held that pass-through income of an S corporation was dividend income and not wages or salary; the IRS appealed to the United States Court of Appeals for the Fifth Circuit and lost. The Fifth Circuit, however, has historically been viewed as unfriendly to the IRS, so when taxpayers on the West Coast, emboldened by the Fifth Circuit decision, began structuring their tax affairs to fully utilize the benefit of the decision from the Fifth Circuit, the IRS chose to challenge the taxpayers. In the much more tax-friendly Ninth Circuit, they suffered another humiliating defeat when the court made it clear that S corporation pass-through income could not be treated as net earnings from self-employment. A few years later, the United States Court of Appeals for the Ninth Circuit made it even more abundantly clear when they declared that “Courts have consistently required shareholders to treat income received as pass-throughs from their S corporations as distinct from income the same shareholders received for providing personal services to their corporation.”  In other words, S corporation distributions beyond base salary are dividends exempt from the self-employment tax. As such, the IRS has administratively treated income attributable to an S corporation as not subject to self-employment tax. The Tax Court has repeatedly confirmed that the pass-through items from an S corporation are not included in the computation of a shareholder’s self-employment income.
To highlight the value of this, let’s use an example. Let’s say Robert is an attorney. Robert earns $200,000 this year. He had $70,000 in expenses, so his net business income is $130,000. As a sole proprietor or even receiving this amount through a partnership, Robert will pay normal income tax as well as self-employment tax of 15.3%, which comes out to a self-employment tax bill of $19,890 not including normal income tax. If, however, Robert makes a retroactive S corporation election and sets his salary at $50,000, his self-employment tax bill will be only $7,650, which is a net savings of $12,240. Over a 20-year career, this simple conversion to an S Corporation will save $244,800. Now you understand why this is a big deal.
Because the courts made clear that only wages paid from an S Corporation were subject to FICA taxes, this led extremely high-earning engineers, doctors, and lawyers generating net income in excess of $250,000 annually to set unreasonably low salaries as low as $20,000 to limit their exposure to FICA taxes. As expected, the IRS began challenging the reasonableness of the artificially low salaries in cases where the amount was indisputably too low.
Although no definitive guidelines address what measure of compensation is reasonable in a particular instance, the courts have identified a number of factors that are probative generally.
Among the factors identified are:
1. The individual’s qualifications;
2. The nature, extent and scope of the work performed;
3. The size and complexity of the business;
4. The prevailing economic conditions;
5. The prevailing rates of compensation for comparable positions in comparable businesses;
6. A comparison of salaries with distributions to shareholders;
7. A comparison of salaries paid with the gross income and the net income of the business; and
8. The amount of compensation paid to the employee in previous years.
This is where the attorneys at Castro & Co. come in. We can assist you in making a retroactive S corporation election, setting a reasonable salary in accordance with case law, and saving you thousands in taxes.
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 IRC §§ 1361, 1362, 1363, 1366, 1367, 1368, 1371, 1372, 1373, 1374, 1375, 1377, 1378, 1379. Congress apparently felt like skipping some numbers.
 See Crook v. C.I.R., 80 T.C. 27 (1983), aff’d sub nom., 747 F.2d 1463 (5th Cir. 1984)
 See Durando v. U.S., 70 F.3d 548 (9th Cir. 1995).
 Catalano v. C.I.R., T.C. Memo. 1998-447 (1998) aff’d, 240 F.3d 842 (9th Cir. 2001).
 Under prior law the Service ruled that income that passed through from an S corporation was not subject to self-employment tax. The Service has not withdrawn this ruling. Rev. Rul. 59-221; see also Durando v. U.S., 70 F.3d 548 (9th Cir. 1995) (income passed through S corporation not earnings subject to self-employment tax); PLR 953005 (losses of S corporation cannot be used to offset net income from self-employment or income subject to FICA); PLR 8716060 (citing Rev. Rul.59-221 with approval). Schedule K-1 for the Form 1120S does not contain any lines for reporting earnings from self-employment, as does Schedule K-1 for the Form 1065. IRS Publication 533, Self-Employment Tax, flatly states that pass-through income from an S corporation is not self-employment income. See Spradling, Are S Corp Distributions Wages Subject to Withholding?, 71 J Tax’n 104 (1989).
 Ding v. C.I.R., T.C. Memo. 1997-435, T.C.M. (RIA) ¶ 97435 (1997), aff’d, 200 F.3d 587 (9th Cir. 1999). In addition to rejecting the taxpayer’s argument that the pass-through items from an S corporation are included in the computation of a shareholder’s self-employment income, the Tax Court also rejected the taxpayer’s claim that because the taxpayer was actively involved in the S corporation’s affairs, the taxpayer should be treated as carrying on the activities conducted by the S corporation.
 For general discussions of the issue, see Hoffman, Heeding Significant Factors Improves the Odds for Reasonable Compensation, 50 J Tax’n 150 (1979); Alvarez, The Deductibility of Reasonable Compensation in Close Corporations, 11 Santa Clara L Rev 20 (1970); McCoskey, “Reasonable Compensation: Do You Know Where Your Circuit Stands?,” 109 J. Tax’n 228. Further, see Wood and Karachale: “Unreasonably Low S Corporation Pay,” 2012 TNT 96-10 and Wood: “Discerning Compensation From Dividends in Professional Firms,” 2012 TNT 134-6. Additionally, see S. Looney and R. Levitt, “Compensation Reclassification Risks for C and S Corporations,” Journal of Taxation (May 2015) and T. Dickens and J. Jahn, “Reasonable Compensation for S Corporation Shareholder-Employees,” Journal of Practical Tax Strategies (April 2015). Additionally, see Klein & Looney, Tax Court Applies Multi-Factor Test to Find Compensation Reasonable, 43 J. Corp. Tax’n 43 (September/October 2016) and Reasonable Compensation Series: Part One, 97 Prac. Tax Strategies 209 (2016). Further, see A. Glogower, Requiring Reasonable Comp From A Corp, 2018 TNT 168-7 (August 13, 2018).
 See, e.g., Mayson Mfg. Co. v. C.I.R., 178 F.2d 115 (6th Cir. 1949); also see Charles Schneider & Co., Inc. v. C.I.R., 500 F.2d 148 (8th Cir. 1974); Estate of Wallace v. C.I.R., 95 T.C. 525 (1990), aff’d, 965 F.2d 1038 (11th Cir. 1992); Richlands Medical Ass’n v. C.I.R., 953 F.2d 639 (4th Cir. 1992); Haffner’s Service Stations v C.I.R., 326 F 3d 1 (1st Cir 2003); Glass Blocks Unlimited v. C.I.R., T.C. Memo. 2013-180 (2013); Transupport, Inc. v. C.I.R., T.C. Memo. 2016-216 (2016) and H.W. Johnson, Inc. v. C.I.R., T.C. Memo. 2016-95 (2016). The Seventh Circuit has adopted an "independent investor" analysis that differs from the multi-factor test in that it inquires whether an inactive, independent investor would be willing to compensate the employee as he was compensated. See, e.g., Exacto Spring Corp v C.I.R., 196 F 3d 833 (7th Cir 2003). For further discussion of the independent investor test, see W Barnard, "The Unreasonable Compensation Issue Rises from the Dead and Takes on the Independent Investor," 93 J Tax’n 356 (2000).
 Under-compensation in years preceding incorporation is, however, irrelevant. See LaMastro v. C.I.R., 72 T.C. 377, 1979 WL 3758 (1979). The Service recently published a “fact sheet” for small business owners in which it advised S corporations of the necessity to treat payments for services to officers as wages and not as distributions of cash to shareholders. The Service noted although there are no specific guidelines for reasonable compensation in the Code or regulations, the courts that have ruled on the issue have based their determinations on the facts and circumstances of each case. The “fact sheet” enumerates several of the factors considered by the courts in determining whether compensation is reasonable in a particular case. See IRS Fact Sheet FS 2008-25 (Nov. 21, 2008).