S corporations are passthrough tax entities (most partnerships and LLCs are, also). Pass-through taxation means that profits are subject to tax at only one level: On the owners' personal tax returns. The entity itself, the S corporation, after deducting its business expenses including salaries and benefits paid to employees (W-2), rent and royalties paid to shareholders or others, business meals, entertainment, and travel, depreciation of computers, office equipment, and furniture, supplies and office expenses, etc., passes through all of its net income to its shareholders as a profit (loss) distribution via a Schedule K-1. That is, the S corp. itself is not taxed on its net profit at the federal, only the shareholders are. (In California, S corporations are subject to a state level 1.5% tax on net profits, subject to an $800 annual minimum.) If the S corporation generates a loss from its business operations during the year, as is common during the first year or two, then this loss passes through to the taxpayer(s) to offset any W-2 or other income the shareholder(s) may have, reducing overall state and federal income tax for that tax year.
The shareholders cannot always pass all profit through to their personal returns, however. IRS rules require that S corporation shareholders employed by the business pay themselves a reasonable salary for their services to the corporation, and payment of self employment taxes of 15.3% on these salaries. This consists of 12.4% on the first $97,500 (for tax year 2007; rises to $102,000 for 2008) of wages and net earnings for social security and 2.9% for Medicare on all earnings. Those used to salaried employment might find these numbers high, because (1) they pay little attention to the payroll deductions from their checks and (2) their employer picks up half of the expense for them. The self employed pay both the employer's and the employee's share, but are then allowed to deduct one-half of this amount on Page 1, Line 27 of Form 1040 without itemizing to arrive at their adjusted gross income (AGI).
Any profits passed through to a shareholder instead of being paid out as wages to that same shareholder results in self-employment tax savings. The economic incentive therefore is to pay salaries to shareholders that are as low as possible; however, failure to pay sufficient compensation to shareholder-employees is a hot area for IRS audits of S corporations. There are no bright-lines rules as to what constitutes reasonable compensation of corporate officers, and although many rules of thumb exist, the amount paid should correlate to what the corporation would have to pay a non-shareholder employee for the same services and should ideally be determined in conjunction with the corporate accountant. During start-up phases were money is tight, or the corporation is not profitable, it may be possible to avoid payment of salaries to owners for a short period of time.
This very issue received some media attention in 2004, because U.S. vice presidential candidate and former trial attorney John Edwards had used an S corp while he was practicing law to avoid payment of approximately $700,000 in self-employment taxes. Edwards' incorporated law practice made approximately $26 million dollars in one year, but his S corporation paid out "only" a $360,000 salary to employee/officer/attorney Edwards, paying the rest out to shareholder Edwards as a profit distribution subject only to regular income tax on his personal tax return. The IRS did not challenge or, as far as we know, specifically review, Edwards' S corporation, and most experts who have commented on the situation doubt that his tax strategy was abusive or likely to be found abusive by the IRS. The IRS currently appears more concerned with those S corporations that fail to pay any compensation to owner-employees, or which pay only minimal or unreasonably low amounts.
There is still plenty of room left in most S corporations to avoid payment of a portion of self-employment taxes as compared to a sole proprietorship (Schedule C taxation), and in some instances, to more than pay for the legal and tax costs of the incorporation, corporate maintenance, and any state franchise taxes, in the first year alone.
The 2008 presidential race may potentially have an impact on the self-employment tax savings strategy in the following ways, most likely if a Democrat enters the White House and also has a Democratic Congress: (1) The payroll tax salary limit may be increased, making the bite of self-employment taxes greater for those with sufficient self-employment earnings; and somewhat less likely, (2) the ability to use the S corporation self-employment strategy may be eliminated entirely (as it already has in the City of New York).
Limited liability companies (LLCs) cannot take advantage of this level of self-employment tax savings because all LLC profits, whether passed to member-owners, or paid out to member-employees as employee compensation in the form of guaranteed payments, are subject to self employment taxes (excepting federal and state unemployment and disability payments, which are not paid by LLC members receiving guaranteed payments for their services to the LLC). The primary exception to this rule for small businesses is an LLC that elects to be taxed as an S corporation. There may be other tax or non-tax related factors that favor using an LLC in any particular circumstance, but self employment tax savings will generally not be one of those reasons.
The first step toward such tax savings is to retain a business lawyer and consult with your accountant to incorporate an S corporation, if appropriate for you and your business(es).