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Self-employment tax and S corporations

Make a mistake with the choice of entity or contract terms when starting up a company and it could have serious consequences down the road. A warning comes in the form of a tax court case decision at the end of December.

Forbes reported on the facts of the case. The outcome was that a licensed financial consultant was hit with a significant self-employment tax liability after income was assigned to him rather than his S corporation. 

Who earns the compensation?

S Corps can pay a salary that is less than gross receipts. The shareholder or employee pays self-employment taxes on the amount paid in wages (In 2017 this is 12.4 percent for Social Security on income up to $127,000 and 2.9 percent for Medicare).

Income earned by the S corporation does not have a separate employment tax. This means that a shareholder would not have to pay self-employment tax on his or her share of S corporation income.

The S Corp paid the financial consultant a salary of $35,000. Net income varied from year to year and was as high as $150,000.

The IRS has the ability to allocate income to the person who earns the income. The issue in the audit and court case was whether the financial consultant or the S Corp earned the service income.

The financial consultant had entered contracts individually with two brokerage companies. Whoever pays the service income needs to recognize the separate corporate entity as well as its legal and actual authority over the individual. So the IRS and tax court treated the commission income as individually earned and subject to a large self-employment tax liability. 

Failure to dot each i and cross each t can prove costly when the tax code is involved. When notified of an audit it may be too late to go back and correct mistakes. Minimize your liability by immediately seeking the advice of an experienced tax attorney.

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