Corporations face two tiers of taxation: one at the corporation level, and another when profits are distributed as dividends to the shareholder. Partnership business entities, meanwhile, are only taxed once to their owners as pass-through entities.

A hybrid midpoint between the two is an S corporation, an entity that can save some types of businesses in employment taxes. But like most tax-saving tools, the S corporation bundles caveats. Here is how to determine whether an S corporation makes sense for your business.

The traditional tax structure of a corporation entails two tiers of taxation. The business itself is a standalone entity that files a tax return and pays taxes on its income, and any of the corporation’s accumulated income that is subsequently distributed as a dividend to shareholders is taxed again — albeit at favorable qualified dividend rates.

However, many small businesses don’t even have a separate entity; instead, they’re simply a sole proprietorship, where the business owner is taxed directly on his/her income. Similarly, many partnerships are really just a combination of individual sole proprietors, and applying this kind of two-tier corporate entity tax structure would be unduly complex, and not representative of the reality — which is simply two individuals coming together in a joint venture.

To accommodate this reality, the tax code recognizes that partnerships can be taxed as a so-called pass-through entity, where even though there is legally a separate business entity, the income is not taxed to the partnership entity, and instead is simply passed through in relative shares to partners’ own individual tax returns. In the process, the two-tier double-taxation of corporate income is avoided.

The challenge for some businesses, though, is that they don’t want to structure the business as a partnership or an LLC taxed as a partnership. In some cases, the liability exposure can still attach to at least the general partners of a partnership. In other cases, there’s a desire to make the business more easily transferrable, especially in small pieces — e.g., for succession planning — and it’s much easier to transfer shares in a corporation than partial interests of a partnership or LLC.

Accordingly, the tax code allows for corporations to make an S election. By electing to be treated as an S corporation, the business is nominally a traditional corporation for legal purposes — with all the usual requirements to establish and maintain a corporation — but, similar to a partnership, is taxed as a pass-through entity.

This allows businesses to enjoy many of the transferability, limited liability and other benefits of a corporation, while still getting the pass-through treatment that avoids two tiers of taxation. Under Check the Box rules, an LLC can choose to be taxed as a partnership, or taxed as a corporation which subsequently can make an S election.

However, to prevent potential abuse, the tax code limits the exact kinds of corporations that can make an S election, restricting both the number of shareholders, the types of shareholders and the classes of stock.

Notwithstanding the restrictions, though, for the typical small business owner who wants some of the structural benefits of a corporation but the pass-through treatment similar to a partnership, the S corporation is an appealing midpoint.

Notably, while S corporations are taxed as a pass-through entity similar to a partnership, the rules are not exactly the same.

When it comes to owners in particular, a key distinction is that with a partnership, any/all income allocable to an active partner in the business is automatically and fully treated as self-employment income, subject to FICA self-employment taxes — that is, Social Security and Medicare employment taxes.

However, with an S corporation, the corporate roots — where payments to owners can occur either as salary compensation for employment or as a dividend to ownership — is at least partially maintained.

The tax code allows for corporations to make an S election.

Of course, it doesn’t make sense to pay a traditional taxable dividend from an S corporation because the whole point is that it’s a pass-through entity, where the income of the S corporation is automatically and already taxed to the owners when the business earns it. As a result, taking money out of an S corporation is simply classified as a distribution. Functionally it’s a dividend, but a nontaxable one because the taxes were already paid when the income was earned by the business to begin with. This ensures that an S corporation is only subject to a single tier of taxation.

Similarly, when an owner-employee of an S corporation receives a salary payment, such as for services rendered to the business, the payment is deductible to the business and taxable to the owner-employee. The net result is substantively the same as an S corporation dividend: The income is only taxed once, to the owner-employee.

An important distinction, however, is that while both the pass-through income of an S corporation and a salary payment from an S corporation are ultimately taxable to the owner-employee at ordinary income rates, their treatment is not identical. Indeed, as corporate income, an S corporation’s pass-through income by default is not subject to employment taxes under Revenue Ruling 59-221, since it was not directly earned — even though it’s otherwise treated as ordinary income. By contrast, a salary payment is fully subject to FICA taxes.

In other words, S corporation owners actually have control over whether they will receive their business income as salary or as a dividend distribution of previously-taxed pass-through income, where only one is subject to FICA taxes but not the other.

The fact that wages from an S corporation are subject to FICA taxes, but dividend distributions are not, can create a non-trivial impact. FICA taxes include a 12.4% Social Security tax up to the Social Security wage base ($127,200 in 2017), plus another 2.9% of Medicare taxes for an unlimited amount of income. In addition, there’s another 0.9% Medicare surtax on earned income above $200,000 for individuals or $250,000 for married couples. In total, this leads to FICA tax rates of 15.3% initially, dropping to 2.9% beyond the Social Security wage base, and rising to 3.8% at higher levels of earned income.

In the logical extreme, then, an S corporation owner should want to pay nothing out as salary and everything out as a dividend distribution — since any/every dollar would save a minimum of 2.9%, and as much as 15.3%.

Recognizing this, though, the IRS still prevents a shareholder-employee from completely avoiding employment taxes by requiring S corporation owners to be paid at least reasonable compensation for their actual services rendered to the business. In fact, for more than 40 years since Revenue Ruling 74-44 was enacted, the IRS has been imputing implied wages to owner-employees who fail to pay themselves reasonable compensation — that is, recharacterizing their dividend distributions as wages, and applying FICA taxes accordingly.

Consequently, if the S corporation earns $400,000 of profits, but the owner-employee did work that would have cost $100,000 for another employee to be hired to do it instead, then the owner-employee must report at least the $100,000 of reasonable compensation that would have been paid for that position, and only take the remaining $300,000 as a dividend distribution.

Notably, the exact determination of what constitutes a reasonable compensation is ultimately based on the facts and circumstances of the individual owner-employee. IRS Fact Sheet FS-2008-25 notes that relevant factors include the person’s training and experience, duties and responsibilities, time and effort devoted to the business, compensation to other non-shareholder employees and what comparable businesses pay for similar services, among others.

Or stated more simply, as the name implies, the owner-employee doesn’t have to be paid the maximum possible, nor any minimum specified amount. Instead, the compensation must simply be reasonable for the services rendered. But clearly $0 of salary and 100% of S corporation dividend distributions is not reasonable compensation for an active owner-employee involved in the business.

Notwithstanding the fact that the tax code requires an S corporation to pay reasonable compensation to an owner-employee, in many or even most cases, an S corporation would still not have to pay all of its profits out as wages subject to employment taxes.

Classifying 100% of S corporation profits as salary might be necessary for a sole owner S corporation with few or no employees, since in that context virtually every dollar of profits really is attributable to the active employment efforts of that owner/employee. But in larger businesses with multiple owners and/or employees who all contribute to the value of the business, at some point of the profits of the business are not just a function of the owner/employee, but also of the value of the business itself.

That could be value created from the services of non-shareholder employees, or from the capital/equipment of the business — both of which the IRS recognizes as being part of the profits of the business, and separate from reasonable compensation of the owner-employee themselves. Or viewed another way, the whole point of differentiating dividend distributions from salary or other wages is that the latter is a reward for working in the business and subject to FICA taxes, while the former is the financial reward for creating a profitable business and not subject to employment taxes.

In practice, this means that owner/employees will often split their total share of the profits between taxable salary wages that are subject to FICA taxes, and S corporation dividends that are exempt from them.

Ideally, though, the split should not be done based on a percentage of the profits of the business, but instead by starting with what a reasonable compensation would be to the owner/employee, with the remaining excess — whatever that may be — paid out as profits.

Example No. 1: Charlie owns a local tutoring business, organizing as an S corporation that has $700,000 of revenue and five employees providing services to customers. In total, his business is on track to generate $200,000 in profits. If Charlie takes all $200,000 as salary, he will pay ordinary income plus FICA taxes on $200,000. If he takes all of the income as an S corporation dividend, he will pay ordinary income on all $200,000 and avoid FICA taxes entirely, but violate reasonable compensation rules in the process.

As a compromise, Charlie pays himself a $110,000 salary, commensurate with what it would cost his business to hire another person to manage his five employees. The end result is that the last $90,000 of profits avoid FICA taxes, of which $17,200 avoids the 15.3% FICA tax rate, and the last $72,800 avoids the 2.9% Medicare employment tax rate, for a total tax savings of $4,743.

In this example, Charlie cannot eliminate the FICA taxes on all of his income, but he can eliminate a material portion of it, including a slice of income below the Social Security wage base that would have otherwise been subject to a 15.3% FICA tax rate. Of course, this presumes that $110,000 really is a reasonable compensation for the job duties he performs in the business.

For larger businesses, often it’s not feasible to push an owner-employee’s salary income below the Social Security wage base because the business is so large, and the owner’s responsibilities are so substantial, that it wouldn’t be reasonable to pay him/her less than a $127,200 compensation package. On the other hand, for very high-income businesses, it can still be appealing to organize as an S corporation, as even just the Medicare tax portion of FICA taxes can still produce material tax savings on a large dollar amount.

Example No. 2: Sheila is the owner of a very successful architectural design firm, organized as an S corporation. Last year, the business generated $2.2 million in gross revenue and a net profit of $600,000. If Sheila were to receive all of this income as a salary or the pass-through from a partnership, it would all be subject to self-employment taxes, with 15.3% on the first $127,200, 2.9% on the next $82,800 and 3.8% on the remaining $400,000, for a total FICA tax liability of $36,773.

To reduce her tax exposure, Sheila declares that she will pay herself a salary of $200,000 as the firm’s CEO, a reasonable compensation for the CEO of a service firm in her industry. As a result, she will still pay 15.3% on the first $127,200 of income and 2.9% on the next $82,800 — up to her $200,000 of wages — but will avoid the 3.8% of Medicare taxes on the last $400,000 of income. The net result is a tax savings of 3.8% x $400,000 = $15,200, by splitting her S corporation profits between salary and dividend distributions.

In this example, even though Sheila is unable to avoid the highest FICA tax rates up to the Social Security wage base, her sheer amount of business income still allows for substantial tax savings by properly classifying a portion of it as a non-FICA-taxable S corporation dividend distribution.

Example No. 3: Jeremy is a solo adviser organized as an S corporation that is a registered investment adviser. This year, he will gross $350,000 in revenue and expects to net $250,000 after paying his administrative assistant and his other business expenses. While Jeremy would like to save on FICA taxes, unfortunately the IRS would likely scrutinize taking any of his business income as an S corporation dividend.

After all, the business revenue is virtually entirely attributable to his services — given that he has no other advisory staff — and there is no capital or equipment producing profits either. As a result, Jeremy will still face FICA taxes on all $250,000 of his S corporation profits, unless he can make a valid case as to why some portion of the revenue and profits really were not attributable to his own work and efforts.

For the typical small business owner who wants some of the structural benefits of a corporation but the pass-through treatment similar to a partnership, the S corporation is an appealing midpoint.

Ultimately, as this final example illustrates, generating FICA tax savings is still difficult for very small businesses, especially service businesses that rely primarily on the services delivered by a single owner-employee. To substantiate a reasonable compensation that is less than 100% of the profits of the business, the owner-employee must have some way to substantiate that a portion of the profits are not attributable to his/her efforts in the business, such that it really would be a reasonable compensation to be paid something less than all the profits of the firm.

Ultimately, for most small businesses, the potential upside of converting to an S corporation structure, or adopting one as an LLC in order to split profits into S corporation dividend distributions and salary compensation, is on the order of thousands — or perhaps a few tens of thousands — of dollars saved in FICA taxes. The opportunity is especially appealing for high-income partnerships, or LLCs currently taxed as a partnership, that have multiple owners and employees with substantial profits, where there is a fairly clear delineation between reasonable compensation for the owner/employee jobs and their profit dividend distributions.

Nonetheless, it’s also worth noting that there are several potential downsides to consider as well.

First and foremost is the cost of making the change itself. There will be filing fees for the new entity itself, but more substantively accounting and legal fees to create the new entity, complete all the requirements to actually form a bona fide corporation — creating and filing Articles of Incorporation, creating a formal leadership team that holds shareholder and director meetings with recorded minutes, etc. — and the time the owners must take to complete the process.

It all means it’s probably not a great strategy to engage in for only a single year’s worth of tax savings. At minimum, the switch should only be done if it’s anticipated to be sustainable and valuable for multiple years, which means the business itself should be longer-term and sustainably profitable.

In addition, it’s worth noting there may be some additional ongoing costs to support the S corporation as well, from a separate business tax return if the business was formerly a sole proprietorship, to setting up or expanding the payroll system and paying unemployment taxes — which may not have already been in place for a solo practitioner-style business, or a partnership/LLC where the owners weren’t on the payroll system — and some states assess an additional tax on S corporations as well. California, for instance, assesses at 1.5%.

The sustainability of FICA tax savings is also an issue because there’s a non-trivial risk that Congress itself will close this loophole. In fact, there have been several proposals in Congress in recent years that would treat S corporation dividends as self-employment income, rendering it fully subject to FICA taxes much in the same way as partnership and LLC pass-through income.

And last year President Obama’s budget proposals included a suggested rule that would subject S corporation dividends to the 3.8% Medicare surtax on net investment income — which means high-income S corporation owners would either find their dividend distributions taxed at 2.9% Medicare plus 0.9% Medicare surtax = 3.8% as earned income, or be subject to the same 3.8% Medicare surtax as unearned investment income, ensuring the government gets its share either way.

The prior legislative proposals have not gained momentum yet, and obviously with a change in president, Obama’s budget proposal will not likely gain traction in its original form. Still, the idea that avoiding self-employment taxes on S corporation dividends is a loophole means there’s ongoing risk that the rules could be altered, potentially quite suddenly.

In addition, it’s important to recognize the limitations of the S corporation itself, and affirm they’re not a problem. This includes the limitations on the breadth of owners — no more than 100, though that’s rarely an issue for small businesses — and the types of owners, as most types of trusts aren’t allowed as S corporation owners, nor can S corporations be owned by many other entities.

For most small business partnerships and LLCs, this may not be an issue, because they may have already qualified as such in many small business contexts. But it’s important to be certain that a transition to an S corporation won’t otherwise throw a wrench in the works of future business plans.

It’s also worth noting that paying less in salary to the owner-employee does have at least some potential downside too. For instance, many/most retirement account contribution limits are based on earned income, so if the owner dials down his/her salary, it dials down the maximum retirement account contribution potential as well — as S corporation dividends aren’t included in determining contribution limits.

In addition, workers only get Social Security benefits based on wages subject to Social Security taxes, which means owner-employees who pay themselves less than the Social Security wage base — which produces the biggest 12.4% tax savings — also reduce future benefits. Whether or not that is material to future Social Security benefits depends on the current 35-year average of the owner-employee’s historical wages, and whether or how new years of continuing to work for wages would impact the average wages on which Social Security benefits are based.

On the other hand, turning wages into dividends above the Social Security wage base is just pure tax savings with no downside, beyond the costs and limitations of creating the S corp and saving at the 2.9% or 3.8% tax rates.

Ultimately, converting to an S corporation to minimize self-employment or FICA taxes probably won’t provide breakthrough tax savings for most, especially since the largest portion will come at the 2.9% or 3.8% tax rates. Nonetheless, the tax savings is real for those who really have profitable businesses — with enough profit to reasonably carve out between dividend distributions and owner-employee salary — and as long as Congress allows business owners to keep making that separation.

Michael Kitces

Michael Kitces

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.