S Corporations – The Missing Perspective

By Garrett Fisher

July 29, 2011

Another rambling tax article? No – while there is some drivel about taxation strategy, the real meat of the matter:  S Corporations and their sneaky effect on retirement planning. Be informed and plan accordingly.

S Corporations have been around for decades. They are a federal tax election intended to allow small businesses to avoid double taxation common with “C” corporations. LLCs generally replaced corporations as the vehicle of choice for small business entity formation and nimble tax treatment. Note that the choice between forming and LLC or a Corporation (done on the state level) has no bearing on taxation. LLCs and Corporations may choose to be taxed as an S Corporation. Old wives’ tales about S Corporations having different legal liability than C Corporations are generally unfounded and irrelevant to day to day business (specific situations notwithstanding). Nonetheless, S Corporation election has a distinct benefit that other tax elections do not: reduction in self-employment taxes.

When a person engages “materially” in the management of a business, that is, they actively manage the operations of a business as opposed to being a passive investor (the rules in this area are very complex on specific situations), they are subject to self-employment tax. Self-employment tax is both sides of Social Security and Medicare taxes. For those unfamiliar, employers pay into both programs the same amount of tax that employees pay. Self-employed individuals must pay both “sides” of the tax. Social Security has a cap of $106,800 in earnings before tax is no longer included on additional wages. Medicare has no limit. SS taxes are 12.4% in total. Medicare is 2.9% in total.

With an LLC not taxed as an S corporation, then self employment tax is applied to the entire amount of net business income, subject to Social Security wage maximums. S Corps allow officers to pay themselves a base salary and then receive the remaining income as distributions. Self-employment tax is paid on base salary. No SE tax is levied on distribution income.

The “gotcha” situation arises from the fact that salaries are paid to active shareholders that are materially managing the business. It is only logical that an investor who is also the CEO receives a salary for his time and returns on his investment for his capital being at risk when there are multiple investors involved (it is further logical that the quiet, uninvolved investor should not pay SE tax on earnings). In those situations, S Corporations function “normally” with no surprise retirement effects. When a single business owner owns the vast majority of the stock in a company and also is paid a salary, then various tax saving methods have sneaky outcomes over the long run.

So, for a business owner that earns net income of $75,000, it would be possible to classify, say $35,000, as salary and remaining income is distributed. Self-employment tax savings would be $5,651.82. No small sum! NOTE: There are specific rules regarding salary classification. It is not a simple “name your price” kind of system to avert tax payment. Talk to a professional or the IRS will be salivating at the thought of reclaiming ill-gotten gains. For businesses earning high amounts ($300,000 as an example), it becomes increasingly difficult to make a case that a salary of $106,800 is not warranted. When that happens, the Social Security argument is completely baseless as the program has been maxed out; however, the Medicare portion of the strategy still offers tax savings possibilities.

So the business owner rejoices at their newfound “savings.” The pragmatic reality is that the taxpayer is not “saving” all of those amounts. Since only their salary is being applied to their taxable Social Security income, then the Social Security program does not factor distributions. Translation: Social Security retirement and disability benefits are negatively impacted. Oh the temptation to take the $5,651.82……

The flip side of the argument is that it is still possible to replace lost retirement benefits and still save a significant sum of money. Let’s assume that the taxpayer in question here is 35 years old with the intention to retire at age 65 and draw SS. They are paying into the SS system at $35,000 per year instead of $75,000 – which will obviously nail retirement benefits. How is the difference made up?

In short, Social Security’s compound annual rate of return for most incorporated business owners born from 1964 to 1985 is from -0.52% to 2.57%. That’s right: for single folks, if payroll taxes are not raised to cover anticipated shortfalls in 30 years or so, the rate of return will be negative (taxes stay the same, benefits drop). For a single wage-earner married couple, assuming that SS raises payroll taxes, the rate maxes at 2.57%. A simple rule: the rate of return goes from low to high – single males, single females, dual wage-earner married couples, single wage-earner couples. For all categories, it is higher for older folks and gets worse for younger. The lower the wage earner, the higher the rate of return. In our assumption, we factored income in the highest bracket available on rate of return assumptions published by the Social Security Administration – which is approximately $69,000 (in line with our assumed income of $75,000).

On the other hand, the stock market has an average 8% annual rate of return. The simple method to make up the difference is to invest an amount of money, at an assumed rate of return of 8%, that will equal the full benefits $5651.82 provides at SS’s rate of return. Using a round number of $100, we arrive at the below:

Amount Invested Rate of Return Ending Balance at 30 years Note
$100 2% $181.14 What $100 turns into with highest SS rate
$18 8% $181.14 The amount it takes in the stock market to equal highest SS rate
$11.54 0.50% $116.14 What it takes in the stock market to equal what $100 turns into for lowest positive SS rate
$8.55 8% $86.04 What it takes in the stock market to equal what $100 turns into when the program is underfunded and goes negative

This analysis presents us with a few issues. First, there is the goal of matching SS’s rate of return. So, for a single person, it’s deceptively “easier” to save less and still match SS. For the married single-earner couple, it costs more to match SS. Second, there is the issue of retirement planning. A single male may elect row 3 and contribute 11.54% of his saved tax dollars and yet find that the result is inadequate (after all, if fully on Social Security, that would have been inadequate as well). It may be more prudent to choose to aim for savings that match a married couple in lieu of underfunding his retirement.

So how I do this again?

First, take the S Corp “savings” amount. Second, determine using the above grid what target amount to invest. For safety’s sake, lets all assume that we are shooting for the highest SS tranche of 2% rate of return. So, using row 2, we find that investing 18% of our tax savings at 8% average annual rate of return would yield the same amount in retirement. For our example of $5651.82, take $1017.33 and skillfully invest it in the stock market (in an IRA or 401(k)). Keep the rest. Those are your savings!

The Pitfalls

Let’s be very realistic.

First, Social Security is a government program. Rate of return assumptions are based on annuitizing benefits. That is, we assume in this article that the SS recipient and our retiree live to be the exact average age of death for a SS recipient. No early death. No ripe old age, either. If an individual follows this concept and lives until 90, they will have seriously underfunded their retirement and would have been better off using SS. On the other hand, if they die early at age 66, they are bequeathing a tidy sum to their heirs. With SS, you get $700 to pay for the funeral. To counterbalance risk, either avoid the strategy altogether or save more than the average assumption included.

Second, the stock market is the stock market. 8% is an average annual rate of return based on historical norms (it does not predict the future). It assumes a sensible point of entry into the market, rebalancing of asset allocation, a diversified, well-managed, low-fee investment vehicle, appropriate reduction in higher risk categories with age and a good market to exit (i.e., don’t turn 65 in a recession). It also assumes that you don’t put your money in loser investments over and over again (there are those with an unbelievable skill in this area). SS is a government program that, while underfunded, will pay out some guaranteed amount of money. It will not leave you with nothing.

Third, we have the disability factor. It is easy to mitigate: get disability insurance. For this exercise, it is very hard to quantify as rates vary by just about every ramification. Benefits vary. The whole concept varies. Suffice it to say that it is not that expensive when we are talking about $4634.49 left over to draw from.

Fourth, this is a serious actuarial study. We used examples at specific current age, specific retirement age, specific earnings amounts. The variables are infinite. Individual circumstances necessary to make a proper decision based on pertinent facts require a professional analysis.

Are we arguing for the privatization of Social Security?


That is a whole different animal that died before it moved very far. Simple fact is: if everyone did it, it would not work. Equity markets would disrupt and blow the entire assumption out the window.

The reality is though, we are dealing with effective tax planning, entities to reduce legal liability and possibly facilitate partnerships, unintended consequence of reducing involvement in the SS program and savings on Medicare tax. In the end, for certain people, an S Corp is far superior than partnership or disregarded entity taxation methods. For those that choose it, it is wise to not fall victim to a surprise at retirement age. Save and invest a reasonable amount of money and come out seriously ahead of the game.