S Corporation or LLC – Employment Taxes
Business Law Corn
Recently I wrote a comment comparing the advantages and disadvantages of operating a small business in each of these entities. One of the advantages of the S corporation discussed was the more favorable tax treatment of an S corporation shareholder (a “shareholder”) who is paid wages for services provided to the company compared to the treatment of self-employment income earned by a member of an LLC (a “member”) that is taxed as a partnership.1
The employment tax rate on wages paid to a shareholder is 6.02 percent imposed by §3101 of the Internal Revenue Code (the “Code”) compared with 15.3 percent self-employment tax imposed by §1402(a) on self-employment income earned by a member of an LLC. The disadvantage is actually significantly less than the difference in these amounts because, the shareholder also bears his pro rata share of the 6.02 percent charge against the company for employment taxes under §3131 of the Code and because of an allowed deduction equal to one half of the member’s self-employment tax.
A more important tax advantage enjoyed by a shareholder is the ability to receive a portion of his compensation as a distribution that that avoids employment taxes altogether. This is true for shareholders of all S corporations including those that are solely in the business of providing services such as law and accounting firms as well as those engaged in other activities.2 Presently, a member of an LLC in a service business must pay the 15.3 percent self-employment tax on the entire amount of his compensation from the company including his share of company profits.
The forgoing treatment of members was confirmed in a recent decision of the U.S. District Court for the District of New Mexico. In Reither v. United States, 2012-2 USTC (2012), a married couple that provided X-ray services reported the major portion of their combined compensation as profits rather than self-employment income on their federal income tax return. They treated the balance as wages. The court held that the entire amount paid should have been treated as self-employment tax citing §1402(a) and Rev. Rul. 69-84. Interestingly, the Service did not challenge the treatment of the remaining portion of the compensation as wages rather than self-employment income. The court noted the inconsistency but did not impose the self-employment tax on the balance, apparently because the IRS did not challenge that treatment.
According to the Shop Talk section of the December issue of the Journal of Taxation,3 a high official of the IRS has reportedly stated that he expects that IRS will issue further guidance on this issue in the near future, presumably because there has been no recent guidance on the issue. Given §§ 707(c)4 and 1402(a) of the Code both of which require partners to treat compensation for services as subject to self-employment taxes, it seems unlikely that the outcome will be any different than that required in Rev. Rul. 69-184 and approved in Reither.
 Under Treas. Reg. §301.7701-2 an LLC may elect to be treated as a corporation.
 In general, courts have been generous in allowing reasonable compensation in these circumstances. In Watkins v. United States of America, 668 F3rd 1008 (2012), the District Court of New Mexico disallowed a salary of $24,000 on total compensation from the plaintiff’s professional corporation of $200,000 but allowed a salary of $91,000 and distribution of $109,000.
 121 JTAX (December 2014) at 283
 Section 707(c) imposes self-employment tax on any payment made to a partner that is not based on his share of company profit.
Posted In: Publications