S Corporation Self Employment Tax: Everything You Need to Know
Self-employment taxes are levied by the federal government against the wages and income of individuals who are self-employed. 3 min read
2. S Corporation Dividends And FICA Self-Employment Taxes
Self-employment taxes are levied by the federal government against the wages and income of individuals who are self-employed. These taxes include federal taxes as well as Medicare and Social Security taxes.
People who are self-employed can structure their business as an S corporation for tax purposes. An S corporation is a hybrid between C corporations and partnerships, and provides the following benefits:
- Protection from liability
- Easier transfer of stock shares
- Pass-through taxation
These factors reduce the amount of money that the business owner will owe in self-employment taxes. Even some high-income partnerships can reap the benefit of switching from a partnership to an S corporation. By switching to an S corporation, the business will split the business profits into FICA taxable and FICA exempt dividend distributions.
In a corporation, you will often face two forms of taxation, both at the corporate tax level and on the dividends you receive on your individual tax return. Running your business as a partnership will allow you to take advantage of pass-through taxation. Under this type of tax structure, the business' profits will pass through the company to the partners as dividends. The partners will then have to include these dividends on their personal tax return, but selecting this structure means that these profits are only being taxed once.
While taxation is definitely a primary concern, there are also other factors that go into determining which business structure is right for your company. While corporations have the right to choose an S corporation tax election, there are eligibility requirements in place to prevent this election from being abused. For example, an S corporation must:
- Restrict the number of shareholders to 100 or less.
- Restrict ownership of stock to individuals, certain trusts, and estates.
- Allow only one class of stock (with the exception of voting and non-voting shares).
- Owner-operators must have direct control over the operations.
- Owner-operators must receive a salary and cannot simply rely on ownership for income.
Many companies might not want to function as a partnership as it can open them up to liability under its structure. Additionally, it is easier to transfer shares of an S corporation without significant tax penalties especially in the event of a succession of the company.
S Corporation Dividends And FICA Self-Employment Taxes
Even though S corporations have the same pass-through taxability that a partnership does, the taxation is not completely the same. In a partnership, any and all income earned by a partner will be fully treated as self-employment income and will, therefore, be subject to FICA taxes including Social Security and Medicare. However, although S corporations are taxed as a pass-through entity similar to a partnership, the rules are not exactly the same.
For an S corporation, payments are made in the form of a salary as the owners are expected to have an active management role in the company. This will replace the normal dividend payments that a stockholder would normally receive under the structure of a c corporation. When owners take money out of a corporation, it is considered a distribution and is not subject to taxes as the business has already paid those taxes when the income was first earned by the business. Therefore, the business owner is only required to pay income tax on their salary. With this taxation method, business owners will only need to pay tax one time.
The salary that the owner-operator will make while working throughout the year at the company is subject to the normal income tax rate. A salary payment will be subject to full FICA taxes. The benefit is that this will give owners the option to choose how they would like to receive their income and ultimately pay their taxes. They can choose to receive it as a salary or as dividends.
While self-employment tax applies to sole proprietors, S corporation officers will not be required to pay it even if they are technically employed by the company. However, if they own stock in the business, they will be required to pay normal employment tax on their stock earnings including Medicaid, Social Security, unemployment insurance, and state and city taxes.
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