Just “Having” an S-Corp May Not be Enough

February 21, 2017 Business planning, Law, Real Estate, Tax Planning Comments Off on Just “Having” an S-Corp May Not be Enough

Just “having” an S-Corporation may not be enough. It’s important you make sure to reap the tax and legal benefits of your S-Corp if you’re going to set one up.

If you routinely read articles in this space or have heard any of our attorneys speak around the country, you are probably aware that we are big fans of the S-Corporation structure as a way for folks who own and operate small operational businesses (i.e. ones where they are selling goods or services and are not someone else’s W-2 employee) to get some limited liability protection and (probably more importantly) to save on self-employment taxes.

When self-employed folks don’t incorporate and instead operate as a sole proprietorship, their entire net profit from the business is subject to self-employment taxes. If you don’t do anything about them, self-employment taxes will eat up about 15.3% of your income – before we even talk about income taxes. So, on a net profit of $100,000, a self-employed person will pay about $15,300 in self-employment taxes

If instead, a self-employed person operates as an S-Corporation, they can do a “salary/dividend split” on the net income from the business. In a salary/dividend split, the business owner will pay himself a “reasonable” salary from the S-Corporation’s profits. A general rule of thumb is that roughly 1/3 of the company’s net profit is considered a reasonable salary. Self-employment taxes are paid on the amount of the salary, and the rest of the income flows through to the business owner as a type of “dividend” from the S-Corporation. That dividend is not subject to self-employment taxes.

So, if a small business owner has the same $100,000 of net profit and operates as an S-Corporation, he will pay himself a “reasonable” salary of about $33,000 and pay self-employment taxes of about $5,000 (instead of $15,300). The remaining $67,000 flows through to the owner free of self-employment taxes. We love the S-Corporation structure for self-employed doctors, dentists, engineers, realtors, commissioned salespeople, certain types of real estate investors, and others whose income would otherwise be subject to the 15.3% tax.

Right now, you’re probably either thinking: “Yep, Jarom, you’re preaching to the choir. I already have my s-corp and I’m saving a bunch on my self-employment taxes!” OR “Man, I need to look into an s-corp right away!” Either way, please keep reading because establishing an s-corp and doing the correct tax filings is only part of the equation.

The recent U.S. Tax Court Case of Fleischer v. Commissioner (2016 T.C. Memo. 238, filed 12/29/16) demonstrates that just having an S-Corporation may not be enough to save on self-employment taxes. Mr. Fleischer is a financial consultant who signed on as an independent contractor representative for a couple different brokerage houses. He also established an S-Corporation, and funneled his income through that entity to save on self-employment taxes in roughly the same way I described above.

So, why was Mr. Fleischer in Tax Court? Well, the IRS sent him something called a Notice of Deficiency. The Notice basically said that his use of the S-Corporation to save on self-employment taxes was invalid, and that he owed roughly $42,000 in back taxes, plus penalties and interest. Mr. Fleischer disputed the Notice, and the case went before a Tax Court judge.

The IRS argued that the Notice they sent was proper because the income at issue belonged to Mr. Fleischer, personally, and not to his S-Corporation. In support of this argument, the IRS presented evidence (which was unrefuted by Mr. Fleischer) showing: 1) Mr. Fleischer signed both independent contractor representative agreements in his personal capacity, not on behalf of his S-Corporation; and 2) Payment for Mr. Fleischer’s work went to Mr. Fleischer personally, not to his S-Corporation’s bank account.

Mr. Fleischer’s primary argument in response was that he had to sign the agreements and receive payment in his own name because he, not his S-Corporation, is licensed and registered as a financial advisor, and it would cost him millions of dollars to get the same required licenses for his company.

The Tax Court wasn’t impressed with Mr. Fleischer’s arguments, and ruled that he was indeed on the hook for all the taxes, penalties and interest the IRS asked for in the Notice. While the Tax Court’s decision in Fleischer isn’t necessarily binding on other cases, it is instructive for those hoping to use the S-Corporation to save on self-employment taxes – and have that use stand up under IRS scrutiny. Namely, it drives home two important points:

1)   To the extent possible, all of your S-Corporation’s contracts – especially those where it will be receiving income – should be in the name of your S-Corporation. This is crucial. One of the huge factors the IRS looks at when determining whether income belongs to a corporation is the existence “between the corporation and the person or entity using the services [of] a contract or other similar indicium recognizing the corporation’s controlling position.” A contract between your S-Corporation and the person or entity paying it will satisfy this factor. Besides, entering into contracts in the name of the S-Corporation also helps from a limited liability standpoint if the other party wants to sue for breach of that contract.

2)   Again, to the extent possible, all payments for goods or services provided should be made to the S-Corporation directly. Such direct payments may serve as “other similar indicium recognizing the corporation’s controlling position.” At the very least, these direct payments will save you from being in a position where you have to explain to the IRS why income being reported through you S-Corporation went first to you personally.

The S-Corporation is a wonderful and legitimate tool to save on taxes. Please just take the time to make sure you are using and operating it correctly. Doing so will save you time, money and headaches if you are ever audited by the IRS (or sued in your business).

About the author

Jarom brings a wealth of experience in several diverse areas of law, but focuses his practice primarily on business formation and transactions, real estate, trademarks, estate planning, self directed IRA law, and civil litigation. Jarom has spent much of his practice helping entrepreneurs and small business owners across the country navigate the trials and tribulations of starting and operating a business. He has helped clients set up hundreds of business entities, drafted multifaceted business and real estate agreements, and represented companies large and small in complex contract, intellectual property and real estate litigation. He also routinely helps clients obtain and protect trademarks and other intellectual property.