S-Corporations and the Old Low Salary Trick
Some people are in love with the s-corporation, because they think they can save a bunch on Medicare and Social Security tax (aka self-employment tax). Here is how that "trick" goes:
Working owners of "flow-through" entities (such as s-corporations and LLCs) are responsible for 12.4% social security tax on the first $106,800 and 2.9% medicare tax on all income paid to them.
The owner of an s-corporation can theoretically save on these taxes by structuring the distribution of the s-corporation's income partly as profit distribution and partly as salary paid to the owner. As a consequence, the owner will only pay self-employment tax on the part he called "salary." Obviously, you can save a lot by paying yourself only a very low salary.
This strategy (paying a low salary) is promoted by many accountants and given as the main reason to chose an s-corporation rather than an LLC when starting a business. But does it work? Not, if the salary is too low.
The IRS, of course, may challenge this approach in an audit and claim that the salary that was paid to the owner was too low and thus depriving the government of self-employment tax. As the Wall Street Journal reports, it happened to this accountant and he lost the fight against the IRS.
**This post is for informational purposes only, For legal advice contact a business lawyer**