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Edwards made $26.9 million as a trial lawyer in 1995, and he minimized
paying Medicare taxes by forming his own S corporation. Edwards paid himself
a salary of $360,000 each year for four years and had the S corporation pay
him the rest in dividends.
Salary is subject to Medicare taxation at a rate of 2.9%, but dividends
escape Medicare taxation. There is no wage base for Medicare, all wages or
salaries are subject to the full 2.9% tax. Social Security does have a wage
base, which means wages above some limit (currently $87,900) are exempt from
the Social Security tax.
So, Edwards saved 2.9% of $25,460,000 or $738,000 in Medicare taxation.
However, sole proprietorships are allowed to deduct one half of what they
pay in Social Security taxes from their income tax (sole proprietors file
Schedule C along with their personal 1040 tax returns). Thus, had Edwards
operated as a sole proprietor, he'd get a deduction for $369,000 from his
income tax. Figuring income tax at the then-current 39.6% rate, he'd reduce
his income tax by about $146,124 if he had filed as a sole proprietor.
Thus, Edwards net savings for forming the S corporation were about
$591,000.
S corporations are useful for small business owners who want to
semi-opt-out of the Social Security System. But, the law requires that
S-corporation owners pay themselves a reasonable salary for the work they
do. Officers of a corporation are considered employees.
Edwards paid himself $360,000 which is probably considered a fair base
salary for a successful attorney. And, because his salary was above the
Social Security wage base, he paid the maximum required by Social Security.
If an entrepreneur earns $80,000 per year and can justify paying a salary
of $40,000 with the remaining $40,000 paid in S-corporation dividends,
Social Security and Medicare taxes are reduced by about $6,000. Over a
thirty-year work history, when investing and compounding are considered,
that can amount to having well over a million dollars more in retirement
funds. This is a big advantage of forming an S corporation.
In deciding what's a fair wage, several factors can be considered.
- How much time and work is involved? Somebody working part time can
justify a lower salary than somebody working full time.
- How much do entrepreneurs and other people doing similar jobs earn? If
your salary is comparable to others doing similar jobs that tends to show
your salary is appropriate.
What the IRS definitely doesn't want to see is an entrepreneur working
full time, raking in $100,000 per year, paying wages of only $5,000, and
removing the rest of the earnings as S-corporation dividends.
Money retained within an S corporation isn't subject to Social Security
or Medicare taxation. If you plan to reinvest your earnings in your company,
this is one potential disadvantage of operating as a sole proprietor or as a
Limited Liability Company (LLC), because the net income of sole proprietors
and active members of an LLC is subject to Social Security and Medicare
taxation. Operating as an S corporation will give you more money to
reinvest. The downside is that you'll have smaller Social Security benefits
in the future.
