Hog image via Shutterstock.
Self-employed real estate brokers and other self-employed real estate professionals must choose how to legally organize their business. The cheapest and easiest option is to be a sole proprietor.
However, another option is to form a subchapter “S corporation” and work as its employee. This is more expensive and complicated than being a sole proprietor, but does have one big advantage: It can save you on Social Security and Medicare taxes.
S corporations can serve as a Social Security and Medicare tax-saving device because employee salary is subject to such taxes, but S corporation distributions to shareholders are not.
Thus, to the extent they pay themselves shareholder distributions instead of employee salary, S corporation shareholder-employees can save big money on these taxes.
Unfortunately, many S corporation owners have gone overboard and had their corporations pay them no employee compensation at all, thus avoiding having to pay Social Security and Medicare taxes.
The IRS Inspector General found that in 2000, about 440,000 single-shareholder S corporations paid no salary to their owners, costing the government billions in lost payroll taxes. As a result, the IRS stepped up enforcement on this issue, auditing thousands of S corps that paid their owners little or no salary.
If the IRS concludes that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can recharacterize the distributions as salary, and require payment of employment taxes and penalties.
The IRS may impose payroll tax penalties of up to 100 percent, plus negligence penalties. It will do so if it concludes that the corporation paid the employee unreasonably low compensation for his or her services.
This is what happened to Sean McAlary, a Southern California-based real estate broker, who formed a single-shareholder Nevada S corporation to own and operate his brokerage business. He was the company’s sole employee, which had eight sales agents working with it as independent contractors.
McAlary’s brokerage business did pretty well in 2006. It had gross receipts of $518,819, deductions totaling $286,735, and a net income of $231,454.
However, the S corporation did not pay McAlary any employee salary or other compensation at all, and didn’t even issue him a Form W-2, Wage and Tax Statement.
Instead, McAlary simply transferred $240,000 from his corporate account to his personal account. As a result, he and his corporation paid no Social Security or Medicare tax for the year.
If this seemed too good to be true, it was. The IRS audited McAlary and had a compensation expert take a look.
The IRS expert concluded that, of the $240,000 McAlary received from his corporation during 2006, $100,755 represented reasonable compensation. In other words, that was the fair market value of the services that McAlary performed for the corporation as its employee that year.
So when McAlary transferred $240,000 from his corporate account to his personal account, the IRS expert concluded that $100,755 should have been treated as employee wages subject to Social Security and Medicare tax.
The IRS expert arrived at his figure by consulting the California Occupational Employment Statistics Survey for 2006, which found that the median wage for a real estate broker in Southern California was $48.44 per hour. That hourly wage multiplied by 2,080 hours (40 hours per week x 52 weeks per year) equals $100,755.
Noting that McAlary’s operation was relatively small and that he had been a broker for only four years, the Tax Court held that a reasonable salary for McAlary for 2006 was $40 per hour ($83,200 per year). McAlary and his S corporation had to pay back Social Security and Medicare taxes on this amount. The court also required him to pay penalties of $7,667.
There is an old saying in tax law: “Pigs get fat, hogs get slaughtered.”
There is absolutely nothing legally or ethically wrong with forming a single-shareholder S corporation to own and operate your business, with you working as its employee. You can save money on Social Security and Medicare taxes this way.
Indeed, this is an especially useful strategy for higher earners now that the top Medicare tax is 3.8 percent on all wage or self-employment income exceeding $200,000 for singles and $250,000 for married couples filing jointly.
However, as the McAlary case shows, you must pay yourself a minimally reasonable employee salary, and pay Social Security and Medicare taxes on that salary.
Had McAlary paid himself an $83,200 salary, his total Social Security and Medicare taxes would have been $12,730. He could have then had his corporation pay him $156,800 as a shareholder distribution, which would not have been subject to any Social Security or Medicare tax.
Stephen Fishman is a tax expert, attorney and author who has published 18 books, including “Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants,” “Deduct It,” “Working as an Independent Contractor” and “Working with Independent Contractors.