38

In the UK an IT-contractor can save in taxes by opening a company, paying themselves a minimum wage as a salary and then taking a larger amount of income as dividends.

  1. Is this possible (for a single-person corporation) in the United States?
  2. If yes, what company form would it require?
  3. What would be the tax consequences? If it is necessary to limit this to a particular state, I live in Florida.
Brythan
  • 20,968
  • 6
  • 53
  • 67
x457812
  • 991
  • 1
  • 9
  • 13

3 Answers3

41

Is this possible (for a single-person corporation) in United States?

Yes, but if the salary you pay yourself is too low then you risk getting flagged for not providing yourself with reasonable compensation. A lot of resources recommend you that you pay yourself partially in dividends to avoid some taxes, as you mentioned is possible in the UK. However if you report no income you will probably be flagged by the IRS triggering an inquiry, audit, and potentially owe back taxes.

If yes, what company form would it require?

This is possible by organization your business into an S Corporation. The linked IRS site contains the necessary forms and instructions to register as such.

What would be the tax consequences?

Generally, you pay employer taxes and employee taxes on your salary but only pay employee income taxes on distributions. Some states (such as California) put extra taxes on S Corporations which may reduce some savings, though Florida's page on S Corporations does not mention any additional taxes. There are also filing and accounting costs associated with registering as an S Corporation. This could cost you around $100.

Nosrac
  • 6,839
  • 26
  • 50
  • 3
    I think your last paragraph is slightly off. You pay no payroll taxes (employee or employer) on distributions, but still pay income tax. – Phil Sandler Jan 18 '17 at 20:31
  • @PhilSandler, thanks for the input! I hope my edit has made that more clear. – Nosrac Jan 18 '17 at 20:39
  • Thank you for the answer. In some other SE post I read about K-1 draw for S-corporations; is that the same thing as dividends or something else? – x457812 Jan 18 '17 at 20:39
  • 4
    @x457812 Strictly speaking, dividends are from C-corps, not S-sorps: http://smallbusiness.chron.com/pays-s-corporation-dividends-55175.html An S-corp uses "distributions" and does not pay corporate taxes, while a C-corp pays corporate tax and then can issue a dividend - which will be taxed again as personal income by anyone that gets them. – BrianH Jan 18 '17 at 20:48
  • 6
    An alternative to actually forming an S-Corp is to create an LLC and elect to have the IRS treat you as if you were an S-Corp. https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc – TecBrat Jan 18 '17 at 20:57
  • In the UK, you would also pay corporation taxes on your profits, and often profit = revenue minus salary paid because such a company has very little legitimate expenses apart from the salary. – gnasher729 Jan 18 '17 at 21:32
  • Again in the UK, if you had to pay yourself a largish salary (instead of about £10,000 a year which is what people usually do), you'd likely leave any leftover profits in the company for when business is bad or when you retire. Plus you can pay about £25,000 a year tax free into a pension fund for the director (which would be you). – gnasher729 Jan 18 '17 at 21:35
  • I've recently reorganized my consulting practice, and the approach @TecBrat mentioned is exactly what I use: An LLC taxed as an S corporation. – chrylis -cautiouslyoptimistic- Jan 19 '17 at 01:08
  • 1
    +1. Given that the question specifically mentions "minimum wage", it's worth noting that in many cases minimum wage would not be considered "reasonable compensation". If you try to set yourself up as a computer tech guy and pay yourself minimum wage when you could get a job doing the same thing for double or triple that, it won't fly with the IRS. – BrenBarn Jan 19 '17 at 05:04
24

Single proprietorships, even if they are incorporated as a limited-liability corporation (LLC), and especially those in which the proprietor is the sole employee, are usually treated as pass-through entities by the IRS, and any "dividends" paid by the LLC to its sole shareholder are deemed to be self-employment income for the proprietor, and not dividends at all. For example, the IRS says

And an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.

That being said, many people do try running an LLC as a corporation (without ever filing Form 8832) for many years before the IRS finally catches on.

Dilip Sarwate
  • 31,562
  • 4
  • 55
  • 122
14

Sometimes an example is worth a thousand words. Let's compare a Sole Proprietorship to an S-Corporation that profits $100K a year:

As a Sole Proprietor with $100K in income (after expenses):

  • Self Employment taxes (FICA) 15.3% = $15,300
  • Note you can deduct the employer portion of FICA ($7650), so your newly adjusted income is $92,350.
  • Federal Tax on $92,350 for 2017 (graduated up to 28%) = $18,839.75
  • Total Tax Paid = $34,139.75

As an S-Corporation with $100K in income (after expenses):

  1. You must choose a reasonable salary. Let's say you decide on $55K.
  2. FICA taxes are only paid on wages, so 15.3% of $55K = $8,415
  3. The employer portion of FICA is $4207.50 so your company income is $100K - ($55K + $4207.50) = $40,792.50 This is the amount that will be reported on your K1 and passed through to you.
  4. Your adjusted income is $55K + $40,792.50 = $95,792.50
  5. Federal Tax on $95,792.50 for 2017 (graduated up to 28%) = $19,803.65
  6. Total Tax Paid = $28,218.65

Summary: forming an S-Corp instead of a Sole Proprietorship where you have $100K in income and you decide to pay yourself a salary of $55K, will save you $5,921.10 in taxes.

Important Notes:

  1. The lower the salary you choose, the more you save on FICA taxes, but the salary you choose must be "reasonable".
  2. With the S-Corp, you will have $40,792.50 available to take as a distribution, but you will pay the same amount in taxes whether you distribute all, some, or none of it. The taxes are based solely on the income; distributions do not affect your tax burden. (With the exception of if you distribute more than you have in income, you will pay capital gains.)
  3. There are some extra expenses associated with having an S-Corporation, but they are certainly less than $6K/year.
Community
  • 1
TTT
  • 47,155
  • 7
  • 99
  • 151
  • 6
    It's been a long day, so, just for fun, I'm going to make a prediction: Someone will claim my math is wrong, and they will be correct. – TTT Jan 19 '17 at 03:25
  • The question is whether $55K is a reasonable wage for the job that you, the employee, did for your LLC. Could the LLC have hired someone else to do the job for the same wage? And don't say that the LLC is a slavedriver with a large whip who could get someone to do the job for peanuts no problem. – Dilip Sarwate Jan 19 '17 at 14:44
  • @DilipSarwate - I completely agree. Not sure if you saw it but under notes I linked to another question which covers that concept well. I once had an accountant tell me, as a rule of thumb, reasonable should be at least 50% of income, or the going rate at which you could hire your replacement. I assume the 50% rule was simply to avoid looking like you're trying to avoid FICA. – TTT Jan 19 '17 at 15:19
  • 1
    The S-Corp will also need to pay Federal and State Unemployment taxes and there is more paperwork involved so a person might be spending more with regards to an accountant. – Benny Hill Jan 19 '17 at 15:23
  • 1
    It sounds like this is just a scheme to get out of paying FICA, and is really just a bet that the system will be insolvent by the time you are old enough to receive the benefits you are entitled to by virtue of having paid into them. –  Jan 19 '17 at 15:49
  • @BennyHill - yep- that's true. As a 1 person company you'll start off at a low to average SUTA rate, so you're typically looking at a few hundred dollars a year in SUTA, and it will decrease each year to the minimum (unless an unemployment claim is filed against your company). Accountant/attorney/state filing costs are all additional costs, but you can still come out quite a bit ahead. – TTT Jan 19 '17 at 15:53
  • @Michael- it is a way to avoid FICA, but it is unrelated to betting on insolvency. Once an S-corp grows large enough that you can salary yourself enough to max out SS, the savings shrink to just the medicare savings, but even there it can still be worth it. If your income is $500K, and you take $150K in salary and distribute the rest, you can still save more than $13K in medicare taxes. – TTT Jan 19 '17 at 16:16
  • @Michael: That probably depends on what the company does. If someone who buys up undervalued thrift-store merchandise for resale at a profit gets lucky enough to find something for $5 which they can resell for $500,000, I wouldn't think the $499,995 profit should really be figured as an "earned wage" in the conventional sense. – supercat Jan 19 '17 at 16:36
  • @TTT - I just brought up the two Unemployment taxes so folks seeing your answer would be aware of them. In 2007 I paid the state of Missouri a little over $1k for Unemployment. In 2008 my FUTA was a bit over $2400. Never had any claims. I think having an S-corp is a good thing though for a number of reasons. – Benny Hill Jan 19 '17 at 22:24
  • @BennyHill - why was your unemployment so high? In 2008 FUTA was 6.2% on 7K, so the max you should have paid for yourself was $434 (or much lower after the state credit). In the case of OP, in FL, new businesses pay 2.7% on 7K for SUTA = $189 and 0.6% on 7K for FUTA = $42, for a grand total of $231/yr. – TTT Jan 20 '17 at 04:31
  • @TTT - I don't have the actual returns here with me, just some notes for/from my accountant. And you're absolutely correct - that FUTA amount I quoted must be wrong. I do remember though that MO Unemployment was high - and I was very angry I had to pay it even though I could never collect on it (as a sole proprietor I could never claim unemployment from my own business). – Benny Hill Jan 20 '17 at 13:43