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Starting Out
In the first few years, there's often little or no income to pass through. There's rarely even enough income to pay the founder and chief shareholder. What there is will be considered wages until the reasonable level of wages is approached. So, when the company becomes successful, the founder may want to pay themselves an increased amount as catch-up for lean years. This isn't a problem in the S corporation, since all income can be passed through. We'll look at the situation for a C corporation later.
Fringe Benefits
Q:How are fringe benefits (used to supplement an employee's salary) treated in an S corporation for tax purposes?
A: It depends on the shareholder-employee's percentage of ownership. Let's take a look…
| 2% or less | Over 2% |
|---|---|
| If the shareholder-employee owns 2% or less of the corporation, then the benefits are deductible by the corporation and aren’t included in the employee’s gross income. | If the shareholder-employee owns more than 2%, the tax treatment is like that of a partnership. The cost of the fringe benefit is deductible by the corporation, but the employee must include the cost as income. However, the employee can deduct 100% of the cost of health care premiums from adjusted gross income on their individual income tax returns if the corporation pays the premiums and the cost of the premiums has been included on the shareholder/employee W-2 as wages not subject to OASID or Medicare. |
Example 2: Black Mesa Products as S Corporation
Andy Redhouse and Loren Bergay decided to incorporate their company as an S corporation. They each paid themselves a salary: Andy received $106,000 and Loren received $62,000. In the same year, Andy and Loren decided that they should establish a medical insurance plan for the company's employees. The monthly cost of this plan (for Andy and Loren) is $500.00 each.
These wages and benefits reduce the original net operating income in the following way:
| Original net operating income | $275,000 | |||
| Less: Wages ($106,000 + $62,000) | $168,000 | |||
| OASDI & Medicare (6.20% + 1.45%) | $12,852 | |||
| Medical Benefits ($500 x 12 x 2) | $12,000 | |||
| Total pass-through income** | ($82,148 x .80) | $65,718 | ||
Andy's income
| Salary | $106,000 | |
| Pass-through income ($65,718 x 0.7) | $46,003 | |
| Medical Benefits ($500 x 12) | + | $6,000 |
| Total Income | $158,003* |
Andy's taxes
Income tax: $17,651 + (24% x [$158,003 – $103,350]) = $30,768
Social Security taxes:
| OASDI | $106,000 x 6.2% | = | $6,572 | |
| Medicare | $106,000 x 1.45% | = | $1,537 | |
| Total taxes | = |
$38,877 |
Loren's income
| Salary | $62,000 | |
| Pass-through income ($65,718 x 0.3) | $19,715 | |
| Medical ($500 x 12) | + | $6,000 |
| Total Income | $87,715* |
Loren's taxes
Income tax: $5,578.50 + (22% x [$87,715 - $48,475]) = $14,211
Social Security taxes:
| OASDI | $62,000 x 6.2% | = | $3,844 | |
| Medicare | $62,000 x 1.45% | = | $899 | |
| Total taxes | = | $18,954 |
* Does not include deductions for medical insurance.
** 2018 20% pass-through income deduction made permanent in 2026.
This example shows why in S Corporations there is a tendency for share-holder employees to be under compensated. Andy may have declared a reasonable salary, reducing his pass-through income, but he could have declared a much lower salary, increasing his pass-through income and significantly reducing his Social Security taxes because they are not calculated on the pass-through portion of his income.
Memory Jogger
In an S corporation, the tendency is for the stockholder-employee to: