LLCs Taxed as S Corporations & Reasonable Compensation
The main reason business owners elect to have their LLC taxed as an S corporation is to avoid the self-employment tax, also known as the FICA tax. However, the S corporation election comes with potentially nasty downsides.
Receiving too little in wages and too much in distributions from your S corporation is one big potential pitfall. So make sure you fully understand the tax consequences of an S corporation before you choose this tax election for your LLC.
Self Employment Tax & S Corporation Election
When you work for someone else, your employer is required to deduct 6.2% from your 2015 wages, on wages up to $118,500, to fund Social Security, and 1.45% of your wages, with no wage cap, to fund Medicare. Additionally, your employer is required to pay the same amount out of its own pocket. So if your LLC wages in 2015 equal $100,000, 7.65% of that amount, or $7,650, will be withheld from your wages by your employer, which it is required to match, for a total tax payment to the Internal Revenue Service of $15,300. (Your employer is also required to withhold an “Additional Medicare Tax” equal to .9% of your wages that exceed $200,000 in 2015.)
Your LLC is regarded as your employer. So generally when you are an owner (member) of an LLC, you get hit with both sides of the FICA tax. However, if you choose to have your LLC taxed as an S corporation, then you pay no FICA tax on distributions that you receive from the LLC.
For example, if the LLC that elects to be taxed as an S corporation earns $100,000 in 2015, the portion of that amount that you receive as a distribution rather than as wages paid to you by the LLC will not be assessed the FICA tax. Obviously you would prefer to receive most if not all of the LLC income as a distribution, FICA tax-free. However, the IRS has the authority to re-characterize distributions as wages, which are subject to the FICA tax, to the extent it determines that the LLC distributions that you received should be characterized as wages rather than as dividend income.
The ugly side to this is that the IRS may take years to reach this determination, and it will attach interest and penalties to the self-employment tax for the time period in which it went unpaid. If you appeal the re-characterization made by the IRS, then the interest and penalties will continue to accrue during the appeal, and if you lose the appeal, then your tax bill may be that much greater.
Reasonable Compensation
If you are an owner (member) of an LLC that has not elected to be taxed as an S corporation, then you will be liable for the 12.4% Social Security tax, up to the wage limit stated above, and the 2.9% Medicare tax, on the income received by you from the LLC, regardless of how such income is characterized.
On the other hand, if the LLC has elected to be taxed as an S corporation, then you will be characterized as a shareholder, and you may receive dividends from the LLC based on the proportion of the total shares of the LLC that you own. Neither you nor the LLC have to pay the self-employment tax on these dividends. However, for the reasons stated above, if you provide labor or services to the LLC, then the LLC must reasonably compensate you for that work, and you must pay the self-employment tax on that compensation.
How to determine the amount of income you should receive from the S corporation as compensation for the work you provided to the LLC is the subject of many lawsuits between taxpayers and the IRS. Unfortunately there is no set formula, and you are therefore in uncharted territory every time you take income from an S corporation in the form of a dividend distribution instead of a wage. (This is typically not an issue for passive investors in the LLC that has elected to be taxed as an S corporation, as they generally provide no service to the LLC, and they will accordingly receive income from the LLC only in the form of dividend distributions. However, passive income may be subject to other additional taxes that are beyond the scope of this article.)
The general takeaway from these lawsuits is that if you are the sole owner of the LLC, then you should probably receive dividend income from the S corporation only under exceptional circumstances where you can clearly demonstrate to the IRS why the wage compensation the LLC paid to you is reasonable. If you are an owner of a multi-member LLC, and you provide services to the LLC, you might be able characterize some of your income as earned by the labor of others, especially if the income was derived from the labor of employees who are not members of the LLC, and receive that portion of your income as a dividend distribution from the LLC.
Determining Reasonable Compensation
McAlary v. the Commissioner of Internal Revenue, decided by the U.S. Tax Court on August 12, 2103, provides a good window into what you need to consider if you are interested in avoiding the self-employment tax by making an S corporation election for your LLC.
Sean McAlary was the sole shareholder of Sean McAlary Ltd., Inc., a real estate brokerage business, which elected to be taxed as an S corporation. (Corporations and LLCs can both elect to be taxed as S corporations.) McAlary held several senior officer positions with the corporation, and he managed all aspects of the company’s operations, including recruiting and supervising sales agents, conducting real estate sales, procuring advertising, purchasing supplies, and maintaining basic books and records. McAlary often worked 12–hour days with few days off. In 2006, McAlary transferred $240,000 to himself from the corporation in dividend distributions, and he claimed no income from the company as wages.
The IRS determined that $100,755 of the $240,000 transferred to McAlary should have been claimed by McAlary as wage income and that the corporation failed to pay self-employment taxes and federal unemployment taxes in 2006 in the amount of $13,693 on this wage amount. Because these taxes were not timely paid, the IRS tacked on an additional $7,669 in taxes and penalties, for a total additional tax bill of $21,362.
The tax court weighed the following factors in determining that $83,200 of the $240,000 should have been characterized as reasonable compensation for the services that McAlary provided to the company: “the employee’s qualifications, the nature, extent, and scope of the employee’s work, the size and complexity of the business, prevailing general economic conditions, the employee’s compensation as a percentage of gross and net income, the employee/shareholder’s compensation compared with distributions to shareholders, the employee/shareholder’s compensation compared with that paid to nonshareholder/employees, prevailing rates of compensation for comparable positions in comparable concerns, and comparable compensation paid to a particular shareholder/employee in previous years where the corporation has a limited number of officers.” Although you should carefully consider each of these factors in determining the amount of reasonable compensation that should be paid to you as wage income by your S corporation LLC, you can probably best determine the amount of income that you and the other members should receive as wage income by determining the prevailing wages paid to employees/officers who perform similar job functions as you.
Conclusion
Tread carefully when deciding whether to make your LLC an S corporation for tax purposes. In addition to the reasonable compensation issues discussed in this article, there are many other tax consequences to making an S corporation election, including taxes on excessive passive income and basis calculations on real estate transferred to the LLC. Seek the advice of competent legal counsel and of a CPA experienced in S corporation taxation before deciding to make this election. In the case of S corporation elections, an ounce of prevention is worth a pound of cure.
The information provided in this article is for general purposes only and is not intended as legal advice. Your circumstances may be unique, and you should therefore consult an attorney for advice regarding any of the issues discussed in this article.
Michael Sewell, MBA, JD, is the principal owner of Sewell Law, LC, d/b/a Sewell Law, which provides affordable legal services to business owners.
You can reach Michael at 314.261.7528, at Michael@StLouisLLCAttorney.com, and at www.StLouisLLCAttorney.com.
