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An S Corporation, or S Corp for short, blends liability protection with tax advantages for business owners. Although an S Corp can be as large as 100 people, the focus of this article is on single member LLCs that file as an S Corp, emphasizing the strategic balance between W-2 wages and S Dividends. Understanding this dynamic is crucial for minimizing tax liabilities and optimizing retirement contributions within the complex framework of S Corp taxation.
An S Corp is a business entity that combines the liability protection of a corporation with the tax benefits of a partnership. Unlike a traditional C Corporation, an S Corp allows income and losses to pass through to shareholders’ personal tax returns, avoiding double taxation.
In an S Corp, income is split between W-2 wages and S Dividends. This is a strategic decision with significant implications for the business owner’s tax obligations and retirement planning. Actively participating S Corp owners, considered employees, are required to receive reasonable compensation for their services, which must be paid as a W-2 wage. The determination of reasonable compensation involves factors such as industry standards, the nature of services rendered, and the individual’s role in the business.
W-2 wages are subject to payroll taxes, including FICA taxes (Social Security and Medicare), which are shared between the employee and the employer. If you are a single member LLC that is filing as an S Corp, both sides of FICA tax are paid by you (since you are the employer and the employee).
On the other hand, S Dividends, representing distributions of profits to shareholders, are not subject to FICA taxes, providing an opportunity to potentially reduce overall tax liability. Striking the right balance between W-2 wages and S Dividends is crucial, as the IRS closely examines cases where W-2 compensation is disproportionately low. While minimizing W-2 wages may seem appealing for reducing payroll taxes, again, it is important to remember that W-2 wages must be reasonable. If you are a specialized surgeon, you cannot get away with paying yourself a $50,000 W-2 salary since the IRS knows this is not reasonable and that the W-2 figure should be much higher.
Additionally, the split between W-2 wages and S Dividends impacts retirement planning, as contributions to certain accounts like SEP IRAs and 401(k) plans are based on W-2 wages. Keeping W-2 wages too low may limit contributions to these retirement accounts, affecting the business owner’s ability to maximize retirement savings. Given the complexities involved, business owners are advised to collaborate with tax professionals to navigate these decisions, ensuring compliance with IRS regulations and aligning compensation strategies with their financial goals.
Next, let’s look at an example of someone earning $500,000 and how splitting income between W-2 wages and S Dividends could potentially save on some tax dollars. This example assumes a flat 30% federal tax and a flat 3% state tax for sake of simplicity. This example also assumes that it is a single member S-Corp, so for Social Security and Medicare, it is assumed that the business owner pays “both sides” of these taxes.
| Scenario 1 |
Scenario 2 |
Scenario 3 | |||||
| W-2 Salary | $500,000 | W-2 Salary | $250,000 | W-2 Salary | $100,000 | ||
| S Dividend | $0 | S Dividend | $250,000 | S Dividend | $400,000 | ||
| Total Income | $500,000 | Total Income | $500,000 | Total Income | $500,000 | ||
| Federal Taxes | $150,000 | Federal Taxes | $150,000 | Federal Taxes | $150,000 | ||
| State Tax | $15,000 | State Tax | $15,000 | State Tax | $15,000 | ||
| Social Security Tax | $19,865 | Social Security Tax | $19,865 | Social Security Tax | $12,400 | ||
| Medicare Tax | $14,500 | Medicare Tax | $7,250 | Medicare Tax | $2,900 | ||
| Total Taxes | $199,365 | Total Taxes | $192,115 | Total Taxes | $180,300 | ||
| Net Take Home | $300,635 | Net Take Home | $307,885 | Net Take Home | $319,700 | ||
| Net Monthly Income | $25,053 | Net Monthly Income | $25,657 | Net Monthly Income | $26,642 | ||
| Tax Savings vs. Scenario 1 | $7,250 | Tax Savings vs. Scenario 1 | $19,065 | ||||
The tax savings is a result of FICA tax reduction since the S Dividend bypasses the 12.4% Social Security tax that applies to first $160,200 of earnings (for 2023), and 2.9% Medicare tax that applies to all W-2 wages. Although in all 3 scenarios the income is $500,000, there can be a big swing in total tax liability depending on how this income is structured.
As mentioned earlier, the split between W-2 wages and S Dividend not only impacts taxes, but also affects your ability to save into retirement plans. Retirement contributions are specifically defined by W-2 wages, so while it may be tempting to pay a low W-2 to minimize current year taxes, this is a delicate balancing act as being “too aggressive” in this regard will limit ability to save for the long term.
Two of the most popular savings plans for business owners are the SEP IRA and the 401(k). Our firm published a blog on this topic that you can view by clicking here. While we will not go into detail about the differences between these plans in this article, we will focus on what you need to know in the context of deciding between W-2 vs S Dividend splits.
SEP IRA contributions are limited to 25% of W-2 wages, not to exceed $66,000 for the 2023 tax year. So if you are looking to minimize current year taxes and pay a very low W-2 wage, it is important to keep in mind that this will limit your ability to save into a SEP IRA.
Continuing our example above, SEP contributions would be limited to the following:
When it comes to 401(k) plans, contributions are still determined by W-2 wage, but can be made dollar for dollar up to $66,000. This is generally split between 3 different components:
Click here to read about how these 401(k) components can be maximized to implement the “MegaBackDoor Roth 401(k)” strategy.
While the W-2 wage in all 3 scenarios above from our example support the full $66,000 contribution, it is still important to keep in mind if you intend on implementing profit sharing contributions. Profit sharing contributions are a pretax deduction for the business, and if you are a single member LLC filing as an S Corp, this tax deduction directly saves you tax dollars for your personal return.
Continuing our example above, profit sharing contributions would be limited to the following:
In conclusion, navigating the intricate landscape of S Corporation taxation demands a nuanced approach to striking the right balance between W-2 wages and S Dividends. The significant implications for tax obligations and retirement planning underscore the necessity of consulting with financial and tax professionals to ensure that strategies align seamlessly with both compliance requirements and long-term business goals. It is recommended that business owners consult with a financial advisor, CPA, or tax professional on these matters.
Important Disclosures:
Securities and advisory services offered through EWA LLC dba Equilibrium Wealth Advisors (a SEC Registered Investment Advisor).
* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
* Past performance does not guarantee future results. Investing involves risk, including loss of principal.
* The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete.
* Consult your financial professional before making any investment decision.
* Content provided for information purposes only.
*EWA does not offer tax or legal advice.
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Important Disclosures:
Securities and advisory services offered through EWA LLC dba Equilibrium Wealth Advisors (a SEC Registered Investment Advisor).
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