Are “S” Corporations Taxed Differently than Partnership?

Both “S” corporations and partnerships are “pass-thru” entities.  This means that neither an “S” corporation nor a partnership generally pays any federal or state income tax.  Rather the income of an “S” corporation or partnership is calculated and reported at the entity level, but is then “passed-thru” to the owners pro rata based on ownership percentage.  The owners then report the allocated income on their personal income tax returns and pay the associated income tax. 

The allocated income of the owner is subject to income tax whether the owner operates in the form of an “S” corporation or a partnership.  There is however a difference in the way payroll taxes and self-employment taxes are applied to “S” corporations and partnerships.  Partners of a partnership cannot be treated as employees for payroll tax purposes.  Rather, all of a partner’s share of partnership income is treated as earned income and subject to self-employment tax. To the contrary, an owner of an “S” corporation can be treated as an employee and paid a reasonable salary.  The owner's salary is subject to payroll tax (which is taxed at the same rate as self-employment income). But the balance of the business income distributed to the owner will not be treated as “earned income” and will not be subject to payroll or self-employment tax.    

Payroll tax and self-employment tax are comprised of two basic parts.  The first is the social security portion which is imposed at a 12.4% rate on the first $106,800 of wages or self-employment income (“wage base”) for 2011.  The second is the medicare portion which is imposed at a 2.9% rate on all wages and self-employment income without limit.  The key inquiry is what constitutes a “reasonable salary.” 

When using an "S" corporation and setting a salary for the owner(s),  the key inquiry is what constitutes a “reasonable salary.”  This determination can be challenged by the IRS, so the amount of the reasonable salary should be fixed after careful deliberation and consultation with your tax professionals.  If a reasonable salary is set and paid, the owner of an “S” corporation will save at least the 2.9% medicare portion of the payroll tax which would otherwise be paid if the business were operated as a partnership.  

Here’s hoping you find this material helpful.  If you like what you read, please forward this on to a friend. 

If something you read here raises a question, don’t hesitate to email or call at Jsenney@pselaw.com or 937-223-1130.  

AND ONE MORE THING:  Do you know anyone having trouble paying their federal taxes?  The IRS offers an Offer-in-Compromise program.  An offer can be made based on doubt as to liability or doubt as to collectability.  Often the IRS will accept an offer to pay that is substantially less than the full amount owed.  Call me if you want to know more about this program.   Jsenney@pselaw.com or 937-223-1130.