This post is meant to be a truthful and brief summary about the benefits, drawbacks and risks of S-Corporations from a tax perspective.  We help businesses obtain S-Corp elections, either initially or retroactively. We assist clients with all aspects of tax compliance with respect to the S-Corporation tax structure.


Under most pass through structures( Schedule C filer or 1065 partner), all of your earnings are subject to employment taxes, and as a business owner/employee, you pay twice, once as an employee at the 7.65% rate, and once as an employer at the 7.65%.  You pay this amount on all earnings up to $128,700.  After you hit this threshold, your only pay medicare tax(2.9%) on the remaining amount. Back before you had your own business and worked as an employee for someone else, you were only responsible for the employee portion of this tax, and you could see it coming out of your check.  Now as a business owner you can really feel the impact of the additional 7.65% tax, and there is no way to make it go away, even with SEP contributions or other front page deductions,  but you can reduce it through the use of an S-Corporation.


By now you’ve probably learned that the S-Corporation offers the most tax advantaged business structure.  This advantage comes from the ability to avoid employment taxes through the exploitation of what Treasury Regulations define as a “Reasonable Salary”.  Consider as an S-Corp owner you have a yearly salary(reasonable) of $30,000, and a remaining profit of $70,000 at the end of the year. You would pay employment taxes on your salary in the amount of $4,590 and an additional income tax on your combined AGI of $100,000. If filing as a sole proprietor or partner(which is the same as taking all of your earnings from salary) you would pay employment taxes on the entire $100,000 which  would amount to $15,300, you’d also pay income tax on your total AGI. As you can see, the S-Corporation structure results in $10,710 savings in employment taxes, this is a material amount. Keep in mind that employer side employment taxes are deductible, so total AGI is less as a sole proprietor or partner, but the deduction is not big enough to make a material impact to the S-Corporation employment tax savings.  I won’t go into any more detail on the mathematics on the tax savings, as the goal is one page for this post, just keep in mind, the smaller the salary amount, the bigger the tax savings, but here is the risk.


There are no specific guidelines for “Reasonable Compensation” in the Code or the Regulations, however this is a matter which has been debated in several court cases. Of course, you want it to be as low as possible, and the IRS want’s it to be as high as possible. The IRS states in the instructions for form 1120S that “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” There are many factors which go into what constitutes a reasonable salary and the courts have looked at the following factors;

  •  Training and experience
  •  Duties and responsibilities
  •  Time and effort devoted to the business
  •  Dividend history
  •  Payments to non-shareholder employees
  •  Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

As you can see, this is all debatable, and every business situation is different. Prior to determining your reasonable salary, we’ll take a look at the facts circumstances around your business and give you an opinion about salary levels which are suitable for your situation.


If you were to be audited and the IRS where to determine that your salary is too low, they will simply reconstitute your profit to salary, and send you a bill for employments taxes, plus a penalty for underpayment. It’s not tax fraud, but it is something you should be aware of. Your savings should be saved, and kept in a “just-in-case fund”, and you should not depend on them to live. The risk/reward window begins to shine light on your side as the years pass, because the IRS audit window is only three years. So if you were to be audited and lose, you’ll only have to pay on three years worth of employment taxes. Other downsides are some of the additional costs you’ll incur such as;

  • payroll service(we can help with this)
  • state level unemployment taxes
  • additional tax preparation fees in some cases

99% of the S-Corporations in the U.S. are owned by a single person, and that person is most likely taking a “Reasonable Salary”.  So with all of these people out there avoiding employment taxes, why hasn’t the IRS done something to stop all of this? After all, they could easily design an algorithm to detect unusual amounts between salary and profits on filed tax returns, or simply look at your profession and salary amounts. Well if you think long term, it could be you that is actually losing. After all, the employment taxes you pay through out life are what determines the amount of social security benefits you receive when you retire, so at some point, without proper planning, you might have some regrets. People are living longer these days, it could be the government who wins this one.


In the end, the decision to operate as an S-corp depends on more than just current tax savings.  The decision requires a little bit of math, some theoretical thinking about the government’s ability maintain the social security and medicare programs when it comes time for you to use them, how much you will have saved for retirement, what the value of a dollar will buy you when you do collect social security and lastly, how long you think you will live.

If your looking for a CPA who can help you to set up and maintain your S-Corporation, feel free to contact us.

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