I was visiting another real estate board yesterday. Someone is saying that there is no requirement for the single member LLC treated as an S-Corp to have the entire net income subject to self-employment income tax when the LLC member neglects to take a reasonable salary.
IRS pub on Small Business Income and Expenses and the Schedule C (1040) instructions only tell me that self-employment taxes are applied to income earned by a sole proprietor or LLC treated as a disregarded entity, but is silent when the business entity is an LLC treated as an S-Corp.
I can’t find a cite in the tax code to refute the widely disseminated advice that all of the LLC (S-corp) income is passed through to the member’s 1040 as self-employment income unless the member takes a reasonable salary. Have I been harboring a huge misunderstanding all this time?
In fact, the code indicates that S-corp income is NOT subject to SE tax. And this is true for owners who are not active in the business. However, elsewhere they state:
“Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
This was done because clever shareholders quickly realized that they were better off to take no salary and receive distributions of S-corp income free of SE.
Thus was born the strategy of taking a reasonable salary, and avoiding SE on the remainder of any distributions.
Technically it’s not subject to SE (and the forms don’t lead you there), but if you’re active in the business and don’t take a salary, the IRS can reclassify it wages and hit you with SE, plus P&I. I understand that they are becoming more agressive policing this, although I’ve never seen it personally. Look for section 1366(e).
Does Section 1366(b) also help us out here?
(b) Character passed thru
The character of any item included in a shareholder’s pro rata share under paragraph (1) of subsection (a) shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.