Warning to S Corporation Owners!Mar 20, 2023
Tax Reasons for the Subchapter S Election
There are lots of great reasons to organize your business as a corporate entity with a Subchapter S election. You have limited personal liability, flow-through of net income, ability to take a Section 199A deduction, and ability to, as the owner, split your income between W-2 and K-1 for tax purposes.
W-2 income vs. K-1 Distributions
The ability to split your personal compensation between W-2 and K-1 can be a huge tax advantage when it comes to Social Security and Medicare taxes. As a corporate employee (albeit of your own corporation) your employer (you) withholds 7.65% in FICA taxes from your paycheck – 6.2% Medicare and 1.45% Social Security. Your employer matches these amounts, and makes periodic deposits of the taxes. Totaled, this amounts to 15.3% of W-2 payroll, a not incidental amount.
But there are no payroll taxes on K-1 distributions. K-1 income is that that is left in the S corporation after all the business expenses have been paid. Income – expenses = taxable profit, and one of those expenses is payroll. So an S corporation owner has great incentive to keep W-2 income low relative to K-1 distributions to save on payroll taxes. And the only IRS guideline is that the W-2 income be reasonable.
Have You Shot Yourself in the Foot?
As we do financial planning for our clients, we sometimes see this: the business owner pays him or herself a low wage, and takes the rest in K-1 distributions, thus saving 15.3% on all those distributions.
Here’s the rub: by suppressing your W-2 income, you also suppress your ultimate Social Security retirement benefit.
Social Security has a complex formula to calculate benefits, but it is based on your earnings over the last 35 years. Log in to myssa.gov, and you can see your entire work history there. Consider this: say your S Corporation pays you $25K in W-2 income, and $75K in K-1 distributions. In so doing you've saved yourself ($75,000 * 15.3%) $11,475 in payroll taxes this year. Not insignificant! But what have you done to your Social Security retirement? For this year Social Security has only $25K on which to compute your benefit.
This has come up in the retirement planning we do for clients. The immediate tax savings is a big temptation. Also on the Social Security site you can do some modeling. Change up your income and see what happens to your benefit. The way to think about it is this: If my benefit increases by, say, $250/month at my age 67, what is the present value of those dollars? And the next calculation is this: what is the future value of the increased payroll taxes on the increased income you used in the modeling - if you invest them? If the future value of the increased taxes is less than the present value of the increased benefit, then you’re better off taking a higher W-2 income in exchange for a higher Social Security benefit.
On the other hand, if you are an extremely disciplined person, and with a long time horizon, you may be better off with the immediate K-1 tax savings if and only if you invest those dollars yourself! It isn't just you that you need to think about here, but also your spouse. When you're gone your spouse has a choice between his or her own Social Security benefit and your benefit - whichever is higher. So if you choose immediate payroll tax savings in K-1 distributions, your spouse may be left with an inadequeate income. Here you'd be well advised to invest those savings to ultimately augment yours and your spouse's retirement income.
This is work that any competent financial planning should be able to do for you. Don’t have one? Then give me a call.
I've previously written a trilogy on Social Security which you may find useful:
Best to all,
--Glenn J. Downing, MBA, CFP®
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