Minimizing payroll tax costs by electing S status for a former proprietorship.

Facts: Martina Ring operates a retail jewelry business as a sole proprietor. In recent years, Martina has been reporting about $50,000 of income subject to self-employment (SE) tax. On average, Martina has. been drawing about $25,000 from the business for personal use, while the remaining $25,000 of earnings is used for debt principal repayment on a large inventory loan arising from Martina's recent purchase of the business. * Martina's SE tax liability for the current year was $7,650 ($50,000 x 15.30% rate). Martina knows she will have to pay income tax on the business earnings under any form of business. However, as a young, single taxpayer without any dependents, she would like to eliminate her SE tax cost. She suggests to her tax adviser that the business be incorporated and an S election filed. Martina further suggests that she draw no salary from the S corporation but, instead, extract about $25,000 annually via distributions, thereby eliminating her Social Security tax liability. Issue: Can Martina eliminate her Social Security tax costs by converting her proprietorship to an S corporation, followed by withdrawal of business income as S distributions rather than salary?

Analysis

There are some basic differences between operating as an S corporation and conducting business as a proprietor, with numerous tax and nontax factors that would need to be reviewed and considered by Martina.

As to payroll taxes, there are advantages and disadvantages of an S corporation compared to self-employed status as either a proprietor or partner.

S Status Advantages

1. The employer's half of FICA is deductible by the S corporation as a business expense. By way of comparison, approximately 50% of the SE tax is deductible in computing the actual SE tax liability; in addition, 50% of SE tax is deductible as an adjustment to income.

2. The FICA tax to an S employee is levied only on actual salaries and wages drawn from the corporation; conversely, as a self-employed proprietor or partner, all trade or business net income is subject to the SE tax.

S Status Disadvantages

Other aspects of the payroll tax system represent a disadvantage if a proprietorship is converted to an S corporation:

1. Salaries and wages drawn by an S shareholder are subject to Federal and state unemployment taxes, while proprietor/partnership earnings are not.

2. The payment of salaries and wages requires payroll tax compliance by issuing a Form W-2 employee wage statement, as well as income tax withholding. This may cause the payment of personal income taxes at an earlier time than if remitted under the quarterly estimate system.

3. The IRS may increase unreasonably low salaries to S shareholders and impose payroll taxes and corresponding penalty and interest assessments.

This last point is of particular concern to the tax adviser. Martina's suggestion to draw no salary or wages from the S corporation ignores the fact that part of the annual distributions from the S corporation would clearly be compensation to her for services to the corporation. The tax adviser explains that the Service has the authority to recharacterize payments from a corporation to a shareholder if those payments involve either unreasonably high or low compensation. The IRS has specifically ruled that distributions from an S corporation in lieu of adequate salary can be recharacterized as salary subject to FICA, FUTA and income tax withholding.

Conversely, Martina's present situation as a sole proprietor often results in unduly high SE tax costs. Martina's proprietorship net income has been averaging about $50,000, resulting insignificant liability for SE tax in recent years. Yet, about half of the business earnings are used for inventory acquisition (debt repayment on the purchase of the inventory) and inventory expansion. This portion of the earnings is attributable to the capital needs of the business and does not reflect the services Martina provided.

By incorporating her business and electing S status, Martina could draw about $25,000 of salary from the corporation (fully subject to payroll taxes) and retain the other $25,000 of earnings within the business for inventory debt retirement and inventory expansion. S income taxed to a shareholder is not considered net earnings from SE and is not subject to SE tax. Further, SE tax is not assessed on distributions to S shareholders.

Before recommending this strategy, the tax adviser also attempts to measure the reasonableness of a $25,000 annual salary to Martina for her services to the corporation. The courts and Regs. Sec. 1.162-7(b)(3) both consider many factors in testing the reasonableness of compensation, including:

1. Nature and value of the services performed, including the responsibilities involved and the time worked.

2. Size and complexity of the business.

3. Prevailing economic conditions.

4. Compensation paid for similar services by similar employers in the same industry.

5. Employee's salary history and qualifications.

6. Employee's contribution to the success of the business.

7. Relationship of the compensation to the business's gross income and net income.

8. Dividend history of the corporation.

The tax adviser cautions Martina on the possibility of a detrimental impact on eventual Social Security benefits from a reduction in her current payroll tax payments. The Social Security system provides not only retirement benefits, but also disability income and benefits to dependent survivors in case of untimely death. Before Martina decides to incorporate and takes action to reduce her payroll tax costs, she needs to determine that her Social Security benefits will not be unacceptably reduced because of her diminished contributions. If she decreases her wages to the point that little or no compensation is subject to Social Security tax, she can become ineligible for benefits under the system.

Conclusion

It is not feasible to totally eliminate Martina's compensation subject to payroll taxes by forming a corporation and electing S status, Rather, Martina will draw about $25,000 of salary per year from the business (representing a reasonable and supportable level of compensation for her services to the corporation), with the remaining income of the business reported by her as undistributed S income. If the S corporation paid her salary of $25,000, the 15.30% combined employer's and employee's shares of FICA tax is $3,825. Thus, by removing $25,000 per year of income from the Social Security tax system, Martina would save $3,825 ($7,650 -- $3,825) in Social Security and Medicare tax annually.

The tax adviser has also suggested that Martina consider the impact of this strategy on eventual Social Security qualification and benefits, and that the selected salary level be reasonable because of possible IRS scrutiny.

Albert B. Ellentuck, Esq.

Of Counsel King and Nordlinger, L.L.P. Washington, DC