While Mitt Romney’s 13.7% effective tax rate finds itself squarely in the crosshairs of both the Republican and Democratic parties, Janet Novack over at Forbes correctly points out that Newt Gingrich used some savvy tax planning of his own to minimize his overall tax liability. Gingrich owns two S corporations, and he leveraged a fifty-year old Revenue Ruling to his advantage by taking “only” $450,000 of compensation from the corporations, while allowing the net profits of $2.4 million to flow through to his individual tax return free from payroll taxes.
In this article published in the Tax Adviser, a certain Aspen-based author takes a thorough look at the issue of S corporation reasonable compensation and explains in detail the mechanism by which Gingrich — and many wealthy business owners like him — are able to save on payroll taxes by minimizing salary in favor of distributions. The article also examines the substantial case history surrounding S corporation compensation, and offers guidance on how to minimize the risk of a successful IRS attack. Fortunately for all, the Tax Adviser article is devoid of the low-brow humor, grammatical errors, and misspellings that have come to define the author’s mildly popular blog:
This S corporation flow-through income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships and LLCs. This advantage finds its genesis in Revenue Ruling 59-221,[i] which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.[ii]
As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax. Consider the following example:
Example 1: A owns 100% of the stock of S Co., an S corporation. A is also S Co.’s president and only employee. S Co. generates $100,000 of taxable income in 2011, before considering A’s compensation. If A draws a $100,000 salary, S Co.’s taxable income will be reduced to zero. A will report $100,000 of wage income on his individual income tax return, and S Co. and A will be liable for the necessary payroll taxes. S Co. will be required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S Co. will withhold $5,650 (5.65% of $100,000) from A’s salary towards A’s payroll obligation, resulting in a total payroll tax bill of $13,300.
Example 2: Alternatively, A may choose to withdraw $100,000 from S Co. as a distribution rather than a salary. S Co.’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis.[iii] By choosing to take a $100,000 distribution rather than a $100,000 salary, S Co. and A have saved a combined $13,300 in payroll taxes.
Now, let it be said, while some may paint Gingrich’s $450,000 salary as unreasonably low — particularly in light of the fact that majority of the earnings of the S corporations appear to be attributable solely to services provided by Gingrich and his wife — there is no precedent in which the courts have held a salary of this magnitude to be unreasonable low.* To the contrary, the majority of IRS challenges have come when shareholders pay themselves less than the social security wage base, thereby avoiding the 12.4% (10.4% in 2011) social security tax on wages below $106,800 in addition to the 2.9% Medicare tax on all foregone wages.
Once a shareholder has paid himself — at minimum — the social security wage base as compensation, the avoided payroll tax becomes limited to the 2.9% Medicare piece, and the risk of an IRS challenge appears to become significantly reduced. In Gingrich’s case, taking a salary of $450,000 allowed him to avoid only the 2.9% Medicare tax on the additional profits of $2.4 million; and while $70,000 is not a paltry sum by any means, it will certainly not go down among the great tax avoidance strategies of all time.
Hat Tip: Tax Prof
[i] Rev. Rul. 59-221, 1959-1 C.B. 225.
[ii] Sec. 1402(a).
[iii] Sec. 1368.
* Also note, Novack’s article does not quantify how much of the $2.4M earnings of the S corporations was distributed to Gingrich or his wife as distributions. There appears to be no significant exposure to an S corporation shareholder who foregoes significant compensation provided they also forego taking distributions; the risk begins when a shareholder draws distributions but not a reasonable amount of salary.