Minimizing payroll tax costs by electing S status for a former proprietorship.

• Author: Ellentuck, Albert B.
• Position: Case study

Facts: Martina Ring operates a retail jewelry business as a sole proprietor. In recent years, Martina has been reporting about $50,000 of income subject to self-employment (SE) tax. On average, Martina has. been drawing about $25,000 from the business for personal use, while the remaining $25,000 of earnings is used for debt principal repayment on a large inventory loan arising from Martina's recent purchase of the business. * Martina's SE tax liability for the current year was $7,650 ($50,000 x 15.30% rate). Martina knows she will have to pay income tax on the business earnings under any form of business. However, as a young, single taxpayer without any dependents, she would like to eliminate her SE tax cost. She suggests to her tax adviser that the business be incorporated and an S election filed. Martina further suggests that she draw no salary from the S corporation but, instead, extract about $25,000 annually via distributions, thereby eliminating her Social Security tax liability. Issue: Can Martina eliminate her Social Security tax costs by converting her proprietorship to an S corporation, followed by withdrawal of business income as S distributions rather than salary?

Analysis

There are some basic differences between operating as an S corporation and conducting business as a proprietor, with numerous tax and nontax factors that would need to be reviewed and considered by Martina.

As to payroll taxes, there are advantages and disadvantages of an S corporation compared to self-employed status as either a proprietor or partner.

S Status Advantages

1. The employer's half of FICA is deductible by the S corporation as a business expense. By way of comparison, approximately 50% of the SE tax is deductible in computing the actual SE tax liability; in addition, 50% of SE tax is deductible as an adjustment to income.

2. The FICA tax to an S employee is levied only on actual salaries and wages drawn from the corporation; conversely, as a self-employed proprietor or partner, all trade or business net income is subject to the SE tax.

   S Status Disadvantages

   Other aspects of the payroll tax system represent a disadvantage if a proprietorship is converted to an S corporation:

1. Salaries and wages drawn by an S shareholder are subject to Federal and state unemployment taxes, while proprietor/partnership earnings are not.

2. The payment of salaries and wages requires payroll tax compliance by issuing a Form W-2 employee wage statement, as well as...