By:  Nate Wilinski & Kirk Licata, CFP®

Did you know that 20% of small businesses fail during their first year and only about half survive through their fifth year?1  Perhaps you’ve made it through a difficult start and have built a profitable business.  Now it’s time to ensure you’re making the most of every dollar.  If your business is structured as a sole proprietor, partnership, or LLC, and you are paying ordinary income and FICA (Social Security/ Medicare) taxes on 100% of your business profits, you may want to consider the pros and cons of creating an LLC or Corporation and filing as an S-Corporation (S-Corp).

When an LLC or Corporation files as an S-Corp, there are two options for distributing business profits to owners: salary & dividends.  Both salary and dividend income flow through to an owner’s personal tax return as ordinary income to be taxed at their federal and state income bracket levels.  However, the salary portion of the owner’s income is subject to FICA taxes while the dividend portion is not.  For high-income small businesses, this distinction can translate to significant tax savings by allowing the business owner to avoid the taxation of Medicare (2.9%) plus the additional Medicare taxes (0.9%) that occur when total income is $250,000 for joint filers and $200,000 for single filers.

So, with the benefit of avoiding FICA taxes when compensating owners with dividends, why would business owners ever pay themselves a salary?  The main reason is that the IRS requires that owners of entities that file as S-Corps be paid “reasonable” wages for the value they add to the business.  Essentially, owners must be paid a salary that is roughly equivalent to the cost of hiring someone in their stead.  Therefore, business owners typically receive some income in the form of a salary and some in the form of dividend distributions.  This balance represents the concept that the owner is both compensated for working in the business and for owning a profitable business that then returns earnings to the owner.  It is important to note that, for some business owners, it is necessary for all compensation to be distributed to the owner in the form of a salary.  This could be the case if all the earnings can be attributed to the value that the owner adds to the business.  For larger businesses, it often makes financial sense to split income between distributions and “reasonable” salaries because the owner is not solely responsible for the earnings generated by the business.  Ultimately, the split between salary and dividend distributions is largely dependent on the structure and size of the business.

Example:  To see the benefit of filing as an S-Corp, let’s look at The Small Law Firm LLC operated by Frank and Fannie Law who are married.  For this example, let’s assume that The Small Law Firm LLC generates business profits of $1 Million.  Frank and Fannie have two employees: an Associate Attorney who is on salary for $175k and an Admin who is on salary for $75k.  If The Small Law Firm LLC were to file its taxes as a partnership, Frank and Fannie would have $750k of income that is subject to FICA taxes resulting in a total FICA tax bill of approximately $59,000.  If The Small Law Firm LLC were to file as an S corporation and it was determined that reasonable salaries for the owners were $200k, then the remaining $350k would be distributed as dividends.  This restructuring would result in a FICA tax bill of approximately $46,000 and a tax savings of $13,000 for their household.  The amounts of federal and state taxes due would be substantially equal in both scenarios.

Now, before jumping to change the structure and/or filing status of your business, there are multiple limitations to consider when regarding a change.  First, when determining how an S-Corp will compensate its owners, you need to consider that social security benefits are based on an individual’s earned income up to an annual wage base (currently $132,900 in 2019), not income received from dividend distributions.  Adjusting your earned income to avoid FICA taxes could reduce your social security retirement benefits considerably if not structured properly.  It is also important to note that a business that chooses to file as an S-Corp may not have more than 100 shareholders and cannot be owned by a trust.  To file as an S-Corp, business owners will likely incur additional fees and accounting expenses such as filing separate tax returns, establishing and maintaining a payroll system, paying unemployment taxes, and facing an additional S-Corp tax in some states.  Lastly, there is always the risk that new legislation will remove the FICA tax exemption of the S corporation’s dividend distributions.

With a newfound understanding of the potential benefits and limitations of restructuring your business and filing as an S-Corp, you may be chomping at the bit to get going and save some money.   However, restructuring your business is no small matter and can be a rather arduous and complex process.  Before making a major change, be sure to contact your CPA and consult with your LongView Advisor to coordinate the best strategy for your financial future.

 

¹https://www.forbes.com/sites/forbesfinancecouncil/2018/10/25/what-percentage-of-small-businesses-fail-and-how-can-you-avoid-being-one-of-them/#2c1463ee43b5