If you work for a company (you get form W-2 at the end of the year), you may not realize that your employer pays half of your Social Security and Medicare taxes. You pay 6.2% Social Security tax and 1.45% tax for Medicare, and your company pays 6.2% Social Security tax and 1.45% tax for Medicare. Social Security and Medicare taxes combined are sometimes referred to as FICA.
But if you have an S-corporation, you are responsible for paying both sides- that is you will be paying 12.4% in Social Security tax and 2.9% in Medicare tax. Here are a couple of things you should know.
- Social security tax is applied only on $142,800 in wages in 2021. If you make more than that, you will not pay Social Security tax for any income above that amount.
- Medicare has no income limit. But if you make more than $200,000, you will pay an additional 0.9%. Note that this additional 0.9% is the responsibility of the employee. Another way to put it, if you make more than $200,000 as an employee, you will pay 1.45% on the first $200,000 and 2.35% on any income over $200,000. As an S-corp owner, you will need to pay 1.45% Medicare taxes for the employer side and 1.45% or 2.35% for the employee side depending on your salary.
If you own an S-corp, you have the option to get paid in two ways – salary and dividend distributions.
- For the salary portion, you must pay self-employment taxes (12.4% Social Security and 2.9% in Medicare taxes).
- For the dividend distributions, you don’t owe any self-employment taxes.
If you want to maximize your income, you will pay yourself 0% in salary and 100% in dividends. Unfortunately, this is likely to invite an IRS audit.
IRS states that
S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
Business owners often struggle with two questions.
- What is reasonable compensation?
- What is the right split between salary and dividend distributions?
First, remember that your business must generate a gross profit before you can pay yourself a salary or a dividend distribution. If your business is unprofitable, you cannot pay yourself.
But if your business is profitable, then you have to decide how much you pay yourself in salary and distributions.
Reasonable Compensation
One way to determine your salary is to look at the salary of similarly employed people.
- For example, if you make Youtube videos, find out how much it would cost if you hire someone to make videos for you. You will end up with a range – someone in New York City may charge $80,000 per year whereas someone in India might only charge you $20,000 per year. Pick a salary that you can explain in case you are audited.
- Another option is to look at the Bureau of Labor Statistics data and pick a median salary for a similar job
Split between salary and distributions
A ratio of 1:1 (also called 50:50 split) between salary and distributions is reasonable in most cases. That is if your business makes $50,000 in gross profits, you can pay yourself $25,000 in salary (subject to Social Security and Medicare taxes) and $25,000 in distributions. If the ratio between salary and distributions is 1:10, in most cases it will raise eyebrows.
Consider your total salary
Your Social Security and Medicare taxes are based on your total income. If you have another job, your employer will pay half of Social security and Medicare taxes for that part of the salary.
Let’s say, you make over $142,800 in your full-time job, your S-corp salary will not be subject to Social Security taxes.
If you make $80,000 in salary at your full-time job, only $62,800 in salary from your S-corp is subject to Social Security taxes (you will pay 12.4% in Social Security taxes on just the $62,800)
As long as you have paid Social Security taxes up to the $142,800 limit, you are less likely to invite IRS scrutiny. If you have a business that generates a huge profit, you can consider a 1:2 or 1:5 split between salary and distribution once you meet the Social Security tax limit. Remember that you will still need to pay Medicare taxes on all your salary since it has no cap.
Bottom Line
Running a business is hard enough for business owners. If you own an S-corporation, you have some tricky decisions to make. Consult a CPA who has experience handling these questions. When in doubt, it is always best to take the conservative route.