Paying a Fee to an S Corp to Avoid Self-Employment Taxes

Sole proprietors and partners who provide services to their partnership business have to pay self-employment taxes on the income they earn from the business.

Self-employment taxes include Social Security and Medicare taxes. The owner of the sole proprietorship is then able to deduct one-half of this amount in determining his federal income tax liability.

Subchapter S corporations can help reduce self-employment taxes by allowing the business profits, whether retained or distributed to the owner, to avoid self-employment taxes.

What happens if a business owner operates as a sole proprietorship and pays a management fee over to an S corporation? Can they avoid the self-employment tax by deducting the management fee for the sole proprietorship and then picking the income up from the S corporation?

The court addresses this in the Jarrett v. Commissioner, T.C. Summary Opinion 2008-94 court case.

Facts & Procedural History

Jarrett operated a tax preparation business as a sole proprietor for over twenty years. Jarrett then formed a separate legal entity as a Subchapter S corporation.

For his 1999 taxes, on his Schedule C for his sole proprietorship, Jarrett indicated that he received $17,444 of income and incurred $16,420 in expenses for his tax preparation services. This resulted in $1,024 of taxable income, which resulted in a $145 self-employment tax liability.

Of the $16,420 in expenses for his sole proprietorship, Jarrett included $7,000 for a payment made to his Subchapter S corporation. Jarrett included a Schedule E with his tax return showing the $7,000 payment as income from his Subchapter S corporation.

On audit by the IRS, the IRS disallowed the $7,000 deduction and included the $7,000 as income on Jarrett’s Schedule C for his sole proprietor business. This increased Jarrett’s self-employment tax liability by about $500. Jarrett contested the adjustment.

About Self-Employment Taxes

Self-employment taxes apply to sole proprietors and partners who provide services and earn income from those businesses. The taxes include Social Security and Medicare taxes, which would otherwise be split between employer and employee.

Sole proprietors pay self-employment tax on their net business income after deductions. The tax rate is 15.3%, with half deductible for income tax purposes. Partnerships withhold each partner’s share of self-employment tax.

These taxes support important social programs, so the IRS closely scrutinizes attempts to avoid self-employment tax on active business income.

The Benefits of a Subchapter S Corporation

A Subchapter S corporation offers business owners tax advantages compared to operating as a sole proprietorship. While sole proprietors pay self-employment tax on all net business income, S corporation owners can structure income as wages or distributions.

Wages paid to S corporation owner-employees are subject to payroll taxes for Social Security and Medicare. But net profits distributed as dividends bypass payroll taxes.

For example, an S corporation owner could pay themselves a reasonable salary reflecting their labor contribution. Remaining profits distributed as dividends escape the 15.3% self-employment tax applied to sole proprietors.

This planning strategy shifts tax obligations while achieving Social Security contribution goals. However, the IRS scrutinizes unreasonable all

Deducting Management Fees

It is common for related business entities under common control to pay management fees to each other for services rendered. However, the IRS looks closely at these arrangements to ensure they are bona fide and not just constructed to avoid taxes.

If a sole proprietorship pays a management fee to a related S corporation it controls, the IRS may argue the S corporation did not actually provide services to justify the deduction. This could be viewed as artificially shifting income to avoid self-employment tax.

Proper documentation of services performed is key. There must be evidence that the arrangement was ordinary and necessary for the related businesses. Otherwise, deductions may be denied and income reassigned.

The question presented in this case is whether a sole proprietorship running funds through a Subchapter S corporation as payment of an expense by a sole proprietorship can help reduce the taxpayer’s combined self-employment and payroll taxes.

The U.S. Tax Court sided with the IRS, believing that the Subchapter S corporation did not provide any services to Jarrett’s sole proprietor business that justified the deduction and allocation of the income to that business.

The Takeaway

This case demonstrates that merely reclassifying active business income from a sole proprietorship to a related S corporation via management fees will likely not circumvent self-employment taxes. The arrangements must have legitimate business purpose with evidence to support the services provided between entities. Without proper structuring and documentation, deductions could be disallowed and taxes reassessed. Business owners should use caution when deducing management fees to related entities.