Small businesses are somewhat notorious for aggressively interpreting the tax code in one's favor, largely because they have a variety of options for doing so not available to the W-2 employee. The game theory sort of incentivizes it, too: heads you save 100% of the taxes at issue, tails you have to pay the taxes at issue and (if you had any sort of a good faith case) only interest at a below-market rate on them... and the coin is known to flip tails only a few percentage points of the time, due to how infrequent audits are.
This is complicated by the fact that, if the tax code were a spec, it would have some requirements which were contradictory and very many interactions whose behavior was totally undefined.
For example, BCC has a fairly similar issue: if the profits are earned income received for the value of my services as an engineer/etc, then they're subject to a generous exclusion since I was physically in Japan when I earned them (foreign earned income exemption, form 2555). If they're unearned income -- that is, if the business is generating profits above the fair market value of the time I am investing -- then they are not subject to that exclusion and I owe the IRS a few thousand extra. On a separate axis, they may not be attributable to the business at all, but as a result of sale of real property, depending on whether the computer software counts as personal property or not, which apparently turns on the degree of support/customization I offer and the mood of the examining IRS clerk. If they aren't attributable to the business and are a sale of real property, then they are excludable, as long as the transaction is not sourced to the United States. Sales of real property are sourced where the transaction physically takes place... but the IRS literally has no opinion on where that is for sales of downloadable software. (I asked. They said "Write up your reasoning with your tax form. If we don't bill you, you're good.") If they are not real property, they may be a sale of computer licenses, which are arguably a source of royalties, which could be subject to a US/Japan tax treaty provision which overrides some of these rules but not others.
The above is not tax advice. Don't even ask about the Japanese side -- I have a few more weeks to figure that mind-meltingness yet.
i just realized the both of us need to start an american-expat-tech-entrepreneur-tax forum. a few other people are in the same boat and email me based on my profile from time to time. I find i know much more about IRS tax code regarding form 2555 than most US accountants because they just don't deal with it much, OR, the ones that have charge way more than I can afford to help me with my questions - but i haven't found a place to discuss these type of issues online. perhaps a google group?
Your position is certainly how things have been for the last 15 years or so. Recently, the IRS is more apt to provide penalties and pretty high interest for perceived underpayment and its your task to prove "good faith" after you've coughed up the fees. This can get costly. Additionally, the IRS doubled its auditors in 2010. Best to ensure your 2555 exemption stays tight as there are few other rocks to hide under these days for anyone but the very wealthy.
I'd like to clarify the issue. Personally, I think that the CPA in question in the article is an idiot for a number for reasons. (1) He's an accountant so he should've known that playing this game with the IRS as a CPA is begging the IRS to slam you. (2) Litigating a losing position like this so publicly is going to kill your reputation and put you on the IRS' top 10 favs list for life.
This is a very clear issue actually and I'm not sure why there is so much confusion and I'd disagree with calling this tax plan a "trick."
It is a legally sound tax plan with a justified theory. You are allowed to exempt a portion of your income from payroll taxes because they are "corporation distributions." Corporate distributions or dividends are not taxed as earned income because they are considered passive investment income. An S-Corp is a corporation that abides under a specific subset of rules within the IRC's Corporation Regulations, thus it is for all legal purposes a regular corporation with certain special rules.
A reasonable salary is a fairly straight forward question. The IRS won't nitpick with you on silly numbers as long as you fit within the range. Obviously, for every position there is a high and low salary range, so as long as you fit within that range the IRS will leave you alone.
The CPA is an idiot because he underpaid himself below market rates to the point where he couldn't justify his position under any reasonable defense.
If you were developer, then you would be paid anywhere from 40k to 250k+ depending on your company, position and experience. Thus, you could potentially pay yourself 40k in reasonable salaries if you owned an S-Corp and take the rest as a dividend. As long as you are able to provide "comps or comparable salaries" to positions with equitable responsibilities and experience in your local region.
The important thing to remember is to be reasonable.
I'm a full-time tax accountant, so this is coming from years of experience in the field with direct contact with auditors from the federal and state levels. They won't come knocking unless you were being a greedy idiot because like the article states it's expensive for the government to audit someone, so when they do audit you it has to be a profitable venture (thus, they usually audit the sure-thing losers).
Does any of this apply if you're not distributing the cash at all? Say, I am making money in my S-Corp, but I keep all of it in the bank (minus the expenses) and instead live off my savings. The plan is to save enough to expand the business, but for now the money is just sitting there, doing nothing.
No that is not going to work. Keeping money in the business is called "retained earnings." Only C corporations or regular corporations are allowed to retain earnings. Pass-through entities such as partnerships and S-corporations are required to pass any income to the owners regardless of whether cash or any other form of income is distributed.
If you want to reinvest into the company, then you'd have to pay taxes on the distributed income and then put the after tax money back into the business, which would increase your tax basis in the company. This would allow you to take net operating losses in the future as well as help you if you ever sell the company.
Hope that helps. Keeping money in the bank won't help you in this situation.
Thanks for your reply. Just to be sure I understand you correctly, which one (if any) is true:
If an S-Corp makes money, it is assumed that the earnings are distributed and thus both personal income tax (on the entire earnings amount) as well as payroll taxes (on the reasonable wage) have to be paid.
Or:
If an S-Corp makes money, it is assumed that the earnings are distributed and the personal income tax has to be paid (on the entire earnings amount), but payroll taxes don't need to be paid.
Option 1 sounds about right. All distributions are going to be tax on your personal income tax and exempt from payroll taxes.
Reasonable wages are NOT corporate distributions, they're simply wages paid by the corporation and deducted as an expense. The payroll taxes would be paid on the amount that you deem wages through the corporation. Please note, payroll taxes are also deductible. hope this helps
See, this points out something I've never understood. If you own an s-corp, you have to be careful about paying yourself too little and taking out too much profit, presumably due to the reduction in FICA withholdings.
So how does someone like Steve Jobs get away with making a $1 annual salary without being charged with tax evasion? It seems like he's found a way to avoid paying into the social security and workmen's comp system.
What am I missing? Is it only legal to dodge withholdings in a c-corp?
His $1 salary is exactly that. A token amount paid by Apple for his work. It cannot be $0, otherwise he wouldn't be considered an employee and wouldn't be entitled to bonuses, stock options, insurance, etc. The fact that he is taking a $1 and tying all of his income to options, bonuses, perks means that he firmly believes his impact to the company will be rewarded - and it has, rightfully so. By taking a $1 salary, you are saying to the shareholders (world) that you believe so firmly in the company, that, you'll earn your income the same way a shareholder would - through the growth in stock price, etc. He does have to pay taxes on personal use of the corporate jets, and other benefits. I can't really imagine his situation being so dire that any social security income he could get would have any material impact on his life. We also don't know what the nature of his contributions were years ago.
Paying too little and taking out too much profit is actually tied to a separate issue. If one runs an S-Corp and is in the typical feast and famine cycle, i.e lots of work, bill lots of money, work slows down, time for lots of sales because there is no work, here comes work again, then, the IRS could say that you took $x+y during the time when you were cash-flush, and $x when you were in your income slump, making $y a dividend and taxed as such. In many cases, dividend income is taxed at a higher rate than personal income until you hit a certain income (I believe $373k/year or so and in 2013, $171k or so). If you earn less than those amounts, dividends are taxed more heavily than normal income.
A C-corp is its own financial entity. It pays its own taxes, has a separate tax structure. If you wanted to pay yourself a $1 salary, you could. Then, any money you take out of the company could be taxed as a dividend, you would have to assume 100% control of your retirement, probably wouldn't be eligible for Medicare after you retire, but, there isn't anything illegal there.
I upvoted you; you clearly know more about taxes than me. However, let me chime in again here and say that the feast-or-famine thing seems overblown. The IRS isn't dinging you for miscategorizing income; it's dinging you for underpaying taxes. You can make your income as irregular as you'd like, as long as you end up paying what you owe.
If your income fluctuates based on profit and the IRS deems that a dividend, then, you are charged at the dividend rate rather than the personal tax rate. That dividend tax rate is higher than your income rate until you hit $373k annual salary in 2011/2012, and yes, you would get hit for underpaying taxes.
Publication 535, mentioned further down under reasonable compensation talks further about how income is qualified.
Basically, if you pay yourself $8k/month, and in July have a really great month and pay yourself $40k, the IRS could determine that the $32k you gave yourself is a distribution of profit, and therefore a dividend. Even paying your taxes as if that was taken as a wage could end up being scrutinized by the IRS. If the IRS determines that your wage fluctuates as much as your profit does, and you're audited, you could have an issue.
Lets say you run a consulting company, pay yourself $5k/month, write an IPhone app, sell $200k, hand yourself $200k right there, it is possible that the IRS could take that view. The difference in taxes on $200k of income versus a dividend is 2% or $4000. If that is greater than 10% of the amount you owe at the end of the year, you could be subject to underpayment penalties of another few hundred. In the fictional $32k, the underpayment of tax would be $3200.
I'm not an accountant, but, if you run into any of these situations, you need to know when to talk with an accountant. Even thinking that you paid the proper tax is something best left to someone that does that for a living. And if you're going to find an accountant, do it in October.. give them your numbers for the current year and what you're projecting for the rest of the year and give them time. You still have room to maneuver a bit more than talking to him on March 14th when the forms are due March 15th. Tax planning is almost as important as tax filing.
Note: yes, I was audited due to the above situation - prior to having an accountant. Ironically, it was a contract with the Navy that did it - I thought, finally, I made this money, I am going to pay myself for all of the hard work I put into this and reward myself for the last two years of subsistance living. After all was said and done, the penalties and accountant fees were grossly disproportionate to the $2100 in underpaid taxes.
> That dividend tax rate is higher than your income rate until you hit $373k annual salary in 2011/2012
It was my understanding, confirmed by your link, that dividends are either taxed as ordinary income or at a maximum of 15% in case of qualified dividends.
You seem like you know what you're talking about so am I missing something?
If I recall, a qualified dividend is taxed as a capital gain - 15% for long term (> 12 months), 35% for short term based on the length of time you held the security/shares in startup/corp/whatever. A non-qualified dividend is taxed at your base tax rate. Bear in mind that a dividend can alter your base tax rate, which affects contributions you may have made throughout the year. So, if you were in the 15% bracket and because of this payment get pushed into the 33% bracket, not only do you need to compensate for the cash received, but, the potential tax liability from your new annual base.
If you are given shares in a company after the initial date, I don't know if that resets the calendar, prorates it, etc.
In my case, as the sole shareholder of a closely held Maryland S-Corp, the IRS deemed the cash payment to be a qualified dividend from a company that was 7 months old, therefore, 35%. Overall, it took roughly 2.5 years and about $7k in accountant fees to reconstruct my bad bookkeeping and deal with the IRS, $1.5k in interest and penalties for an unpaid $2100 tax liability.
Again, if your income ever goes crazy for whatever reason, talk with an accountant.
You really can't "cheat" with a C-corp. Your company's income is going to first be subject to corporate income taxes (30 to 35%). Then if you pay dividends, that is also taxed.
In other words, trying to skirt payroll taxes with a C-corp is going to end up with you paying more taxes than doing no hack. Hence, why the IRS rule only applies to S-corps which pass on their income and are not subject to corporate taxes.
Steve jobs effectively pays a 45% federal tax rate on income (35% corp on apple's income and then 15% long term cap gains on any shares he sells) -- so the IRS really doesn't care.
That's probably effective after all deductions, etc. 35% should be their marginal rate. So if the last $500k of income was converted into Steve's Salary their taxes should be dropping by 0.35*500k
A S-corp owner must take what the IRS deems to be a "reasonable salary" based on the overall profit of the company, and must pay self employment taxes (FICA, Medicare, etc.) on that amount.
The IRS does not give out much guidance on the definition of "reasonable salary" but has provided guidance on what is /not/ reasonable.
In this case the IRS evaluated the company's return and decided that his salary was less that reasonable and as such they went after him and got him to pay more tax.
To be clear: the rule doesn't apply to C Corporations because they are taxed differently; it's not an oversight. It's the pass-through taxation structure of S Corporations that make this an issue.
If you are a C corporation, you get no pass-through. My consulting business is set up as a C corp, and my accountant makes sure that it earns no profit each year. This is mostly done by paying any excess as salary bonus. Corporate tax rate is too high to leave money there.
The C corp cost me a little more in terms of the deductions, but was a big win because when I set it up many years ago I put in the bylaws a medical provision such that any full-time employee would have health coverage (up to a limit) including health insurance premiums. This, due to the very high cost of health insurance, was a big win, as these are a business expense.
Were I to do it again, I would probably do LLC with the new way that health care is taken care of.
Thus, there is no issue like there is with the S-corp, because any money taken out of the corporation is done through payroll.
Social Security/Medicare/Workers comp get no money on passthrough from a c-corp either - c-corps pay taxes on profit, whereas s-corps pass any profit through to be taxed on individual returns of shareholders.
What would bother the IRS is that capital gains distributions are taxed at a different, lower rate than standard income, so taking distributions instead of income could reduce the total amount owed to the IRS.
(I'm not an accountant - if someone could verify or refute this, that would be nice)
Aside (but relevant): some countries have as an explicit rule, that if you get a letter from the IRS on an issue, both you (as someone who has to comply with the law) and the IRS itself, is bound by the interpretation that is given.
In the USA, even if you get a private ruling, the IRS can decide to renege on their advice at any time, and investigate you and charge you, making you pay penalties and fines for following their own advice.
These ambiguities and "tricks" could be cleared up with simple guidelines backed up by such private rulings; however that would not be in the best interest of our "gotcha now!" system of taxation.
There is so much "waste motion" expended in trying to game the tax code in so many situations... what could creative people achieve in that time if they didn't spend it that way. We need a vastly simplified income tax code... I'm talking throw it all out and start from scratch. Or replace it with a national sales tax, rebating some amount to make it less regressive.
I'd like to clarify this argument. This is often a cited "alternative" A national sales tax won't be a simplified cure. Current sales tax laws issued by the states are considered fairly simple. Whatever you buy is taxed at X rate. But, from years of experience in sales tax, it is one of the most complicated areas of taxation that is constantly changing.
Ex: Have you ever wondered why supermarkets are designed the way they are? Tax is the reason why every major supermarket redesigned their layout years ago. There is a landmark case that argues whether a snickers bar is considered food or candy. Two categories with different tax rates. In the end the judge stated that candy is anything sold at the register counter and food is anything held within the isles.'
Simplification is an ideal that never pans out because we're always going to look for the loophole and its our own ingenuity that made the current IRC so complicated. Everything starts out simple until life gets a hold of it.
This implies that if you simplified the tax code, people would stop gaming it. The opposite is probably true; the simpler you made the tax code, the more accessible tax games would be to average taxpayers.
I don't agree. In order to game, there has to be different rules to take advantage of. The fewer and simpler the rules, the less you can manipulate it. Take sales taxes, for example. You can't really game them. You can evade them, but not really game them, although I suppose mail ordering things from another state could qualify, but that's an issue of jurisdiction.
> I suppose mail ordering things from another state could qualify
You're supposed to pay "use tax" on those, which for some reason is always equal to the sales tax you think you avoided. So it's still evasion rather than gaming.
Which is why you simplify it in such a way as to make tax games impossible.
Here's my favoured solution: the US Government spent $3.6 trillion this year. There are 280 million people living there. Therefore, Federal tax should be a flat $12,857 per person.
For the average income earner, this is about the same as they're already paying. For those earning more, they find they're incentivised to work harder, since every dollar they earn beyond that point is entirely their own. And for those earning less... well, it's the kick in the butt that they need to start working harder too.
"The kick in the butt they need"? Under that system there would presumably be a considerable number of people who could no longer afford to live - a family of four would be taxed over $50,000 which they might well not be able to earn, let alone earning enough more than that to pay rent and buy food. Not everyone can be an above-average earner.
I'm all for the idea of simplifying tax systems, but your idea doesn't remotely work.
I hope I don't get slammed for this, but the tax code is a large pile of stinking dung, and good luck trying to do the right thing.
S-Corps work under the general premise that it's just like you, if you were a corporation. So if you don't spend all the income in your business in the year, you owe income tax on what remains. If you have plenty of profits, you write yourself a regular W-2 paycheck. At the end of the year, whatever you don't spend as a legitimate business expense -- even if it's exclusively for business purposes -- is taxed at the same rate as if you had spent the money on whiskey and hookers.
Case in point: there is a huge difference between a high-income wage earner who uses S-Corp status for maximum flexibility and the local beautician or mechanic who does the same thing. Lots of independents who are S-Corps have highly volatile income: if you get a client that writes you a check for 50K in January that might be the last income those guys see for that year. So those guys have to make a difficult business decision as to what to do with the money, and the most logical thing to do is to pay business expenses as needed and withdraw the rest as cash disbursements only as a last result. Writing yourself a W-2 paycheck when you're not sure of future income is basically taking away spending money from the business for no logical reason. As I understand it, the system is designed this way on purpose: tough times allow S-Corps to ride on profits and re-tool for the good times. Good times S-Corps work just like "regular" businesses.
So for small folks with highly-volatile income, being able to move funds around is the only thing sometimes that keeps them afloat. Unfortunately, there are a lot of guys making 400K a year or more who pay themselves a salary of $20K and take the rest as cash disbursements (thereby avoiding paying themselves as W-2 employees mostly altogether)
The reason the tax code is such a mess is that folks get mad at one bunch or another that they think are not acting fairly, so they punish them -- usually punishing many more than the original target. Or politicians want extra votes, so they make an exception for certain people -- usually providing exceptions to hidden interests and creating perverse incentives. 60 years of this and you have a complete disaster.
So yes, by all means make folks pay their share, just be aware that the guy you read about in the paper isn't necessarily the average guy. It's not an "income trick" if it helps the economy grow.
Respectfully --- I like you and your comments, even though our politics couldn't be more different --- you should get slammed for this analysis. You're muddying the waters and you know it.
The prevailing market wages for beauticians and mechanics are so low that that benefit of evading FICA is marginal. S-Corp owners are rarely audited period, but here you ask us to consider that enforcement of the tax code might focus on them. Of course it doesn't.
Moreover, you've conjured up this issue of income flexibility, the idea that feast-or-famine will cause people to need irregular salaries. But that's not an issue at all. You can pay yourself an irregular salary. Just make sure your quarterly estimated tax payments treat most of it as payroll. The only time this S-Corp rule becomes an issue is when you explicitly invoke it to avoid FICA. Don't do that.
It is not difficult to avoid the problem this article talks about: unless your salary approaches the FICA cap (last year it was just shy of 100k), don't pay yourself a significant fraction of your total income in distros. What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole.
> What makes this a particularly easy rule of thumb to follow is that it's exactly what you would do anyways if you didn't know about the S-Corp loophole.
So if everyone is supposed to pretend it doesn't exist, why does it exist?
The tax structure S-Corp owners are taking advantage of is the one that governs investment income. These people are deliberately reclassifying their compensation as return on the investment of having started a business.
Well in this case it really is an income trick. I have friends who do S-corps for this reason and the main thing they stress over is paying themselves a fair market salary. The guy in the article was paying himself barely 1/2 what a new grad would make so it's clear that he was well below fair market.
If he had just paid himself fair market he would still have come out ahead and not had to deal with the IRS.
I think there's a lot of smoke being blown about the "fair market salary" thing, as if the IRS was capriciously planning the US economy during audits. It seems to me --- and I'm prepared to be wrong here --- that the deal is simple: look at your quarterly estimated payments, add up all your income, and if it looks like you're getting a significant break on FICA because of the way you've structured your income, fix it: there's no free lunch.
I disagree unless the payment you are making to yourself as distributions is fair compensation for services provided to the company. A company's purpose is to make a profit, and if you are distributing profit to yourself, then there is no reason to pay FICA on that income. The "fair market salary" is important because if you are forced to pay yourself arbitrarily more (like you suggested), it would be in the best interest of the person to instead hire someone to do his job for him (at fair market salary) and simply collect the profits. (In fact, this could be the long term goal: hire someone to manage the business and retire on the profits!)
If you'd like to know why it's "fair" for people to be allowed to pay income tax and not FICA tax on profit, then you need to look at the C corporation code. Under this system, the corporation pays a corporate income tax, and then can pay profits to its shareholders as dividends, which are then also subject to a second tax. You'll note that there is no payroll tax in this system. The purpose of an S-corporation is to avoid this "double taxation" for very small companies and instead use the personal income tax code, which may be (but is not necessarily) cheaper for the shareholder. This is not a loophole: it is by design.
It is also worth noting that just because the taxes are paid through the personal income tax code, that doesn't mean that person received that profit as a cash distribution. That money may very well be put to a different purpose, e.g. investing in the business in some way which is not yet tax deductible (like a large capital purchase), in the bank as float, or invested in some way.
In the case mentioned in the article, I certainly agree the owner was not paying himself enough by W-2 for his services, particularly if he was the sole employee and otherwise received that income as a cash distribution. He is obviously an experienced CPA who would be paid much more on the open market, and as a CPA, he should have known better.
Can anyone comment on how personal income tax is handled in other countries? I don't mind paying tax but I hate the fact that I can take my paper work to several different tax preparation services and get different tax bills. In some cases I have heard of people owning the IRS thousands, going somewhere else and claiming a refund.
Is the US the only country in the world where 2 to 3 percent of our GDP goes into tax preparation?
In the UK personal taxes are generally automatically handled by the employer. You just get the post-tax income transferred into your bank every month, and a payslip showing the deductions that were made.
(Outsourced PAYE administration costs about £20 per month for a very small company.)
It gets more complicated when you can't do taxes through PAYE for any reason - unearned income, dividends, directorships etc.
My own taxes as a director of two firms subject partially to mandatory PAYE on some of my income are a US-level nightmare and once you are out of the 'simple system' getting back into it takes years.
I read a book by Jim Rogers, I think it was "Investment Biker" and he said that the US is the laughing stock of the developed world because of the way our incomes taxes work. He said that in Australia you have one form the size of a postcard that everybody mails in once a year.
While I agree with you, it's not entirely true that you have one form that you post in once a year. While your 'group certificate' is postcard size, I think it's somewhat like a W2 (been a while since I received either), you still have to submit a personal tax return. For most people, it's just a case of reporting the information on the Group Certificate(s) (depending on how many jobs you had) and perhaps claiming on some deductions like uniforms or (new) secondary school expenses for dependent children.
That said, the government is talking about moving to a model whereby you don't have to submit a return unless you specifically want to claim some deductions. This is more like the UK model.
As for the US being the laughing stock - I don't know if I would choose those words, but I do think the IRS needs its wings clipped by foreign governments. The whole W8BEN form thing is ridiculous (so tempted to put F.YOU IRS as my contact details) as is the mind-boggling fact that the only way to not file a return in the USA is to renounce your citizenship (and good luck visiting your relatives after that!).
The myriad of local, state and federal taxes, forms, rulings and corporate structures - well, I do wonder how much GDP is lost in paper shuffling. It can't be insignificant.
Personally, I would have the tax laws in most countries scrapped and replaced with flat-banded taxes with zero exemptions. The tax rates would be lower to make up for the lost deductions, but in general, if you earnt X, you'd be up for taxes of Y. Corporations would be kept for their original purpose of limited liability rather than taxation structures. As noted above, it's all the special interests that get in, and, well, anyone who was tried to selectively reward children will know the impossobility of 'fair' once selective rewards and exemptions are introduced.
Seems like if we just had a large sales tax, rather than income taxes, none of these things would be so complicated, and we'd save so much money on the cost of compliance.
A large sales tax is an unfair tax on the poor. Why should people making $20,000 a year pay the same tax on their groceries as someone making $1,000,000 a year?
That's why nobody would set it up that way. The government (in this scenario) could afford to send cash money to all households to cover the tax cost of food and minimal living expenses such that the only taxes paid are for expenses beyond that minimum. A large sales tax would actually work out very well and be rid of the complexities of the IRS completely. I'd encourage anyone curious about how this would work (regardless of your initial reaction to the idea) to check out the reading material on http://www.fairtax.org/ .
If consumption is taxed the poor will have less purchasing power. If production is taxed the poor will have less jobs and less money. Empowering the poor will not come by penalizing production or consumption, but by empowering the wealth producers.
I'm not advocating replacement of income tax with higher sales tax; just answering your question.
I wouldn't consider myself the most knowledgeable on this issue but I think there's an argument for a system that doesn't tax certain basis necessities and offers compensation to the poor to allow for more than just an existence.
It's not a "mandatory minimum wage". Stop trolling. You can pay yourself $0.50/yr if you'd like; you just can't do it will paying yourself tens of thousands in distributions.
This is one of those few instances where I actually support the IRS and also support the law that's being contemplated.
S corps (and AFAIK LLCs) are supposed to have "pass through" taxation. I think it's fair that all income (whether salary or profit distributions) from S Corp is treated as regular W-2 income.
If you don't care about the simplicity that "pass through" offers, register a C-corp.
So then as a small Sub-S owner (wife and me), I would have to pay FICA and Medicare on the money spent on health care insurance, disability insurance, etc., which you as a W-2 employee do not pay payroll taxes on.
In the end, the payroll tax savings are not that great for a small Sub-S. And as you get older, toward retirement, if you pay yourself too low, you take a big hit on SSA benefit payments (which are based on your latest 40 qtrs).
The biggest bang for the PIA effort is if to can write off a vehicle purchase through a Section 179 deduction, and various other hardware purchases.
The tax code already goes way, way out of its way to make it easy to pay for health insurance; get a high-deductable plan and build an HSA. It's what you should be doing anyways, even if you don't care about taxes.
The fact of the matter is, as a member of the workforce, you owe FICA on your compensation. This isn't a subject of dispute. The IRS says you do, the courts say you do, your accountants will say you do. This issue comes up on HN roughly once a year, and the story has never changed.
"...you owe FICA on your compensation". Exactly. I want to be taxed (and get the same breaks) as my corporate client employees. Business writes off all possibly related equipment, as do I. I try to write off everything a C-corp would for employees, but it is much more difficult for us (and very time-consuming even trying to be IRS-compliant).
Again, payroll tax savings (on the income/distribution differential) does not usually add up to that much money.
Since you asked me, yes, my two cents is if you pay for insurance out of distributed profits, you should be treated exactly the same was as a W-2 employee with no health benefits buying insurance on his own would be (I'm stating it this way because I don't know the payroll tax situation for a W-2 employee w/o benefits buying them himself).
If the benefits are provided by the S-corp to employees (i.e., to you), I don't think the question arises. The money used to buy the employees' insurance is removed from the profits, so it won't be part of distributed profits. Since tax is only on income, you won't pay taxes on insurance.
> The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file as a corporation, partnership or sole proprietorship tax return.
As for your suggestion that all pass-through income is W-2 income - that would never work. It implies that all business "profits" were paid to its shareholders (that's what payroll / W-2 income is). A cash distribution to its owner is not the only thing a company chooses to do with its profits!
I don't know how it is for S-corps with passthrough, but for LLCs opting for passthrough taxation results in exactly what you describe: you owe taxes even though the profits were not distributed to you because the company decided to reinvest. Search for "allocated profits", "distributed profits", and "phantom income". You owe taxes on allocated profits, not distributed profits.
Opting to be taxed as a coporation (or C-corp) avoids all these problems (at the expense of "double taxation").
This is complicated by the fact that, if the tax code were a spec, it would have some requirements which were contradictory and very many interactions whose behavior was totally undefined.
For example, BCC has a fairly similar issue: if the profits are earned income received for the value of my services as an engineer/etc, then they're subject to a generous exclusion since I was physically in Japan when I earned them (foreign earned income exemption, form 2555). If they're unearned income -- that is, if the business is generating profits above the fair market value of the time I am investing -- then they are not subject to that exclusion and I owe the IRS a few thousand extra. On a separate axis, they may not be attributable to the business at all, but as a result of sale of real property, depending on whether the computer software counts as personal property or not, which apparently turns on the degree of support/customization I offer and the mood of the examining IRS clerk. If they aren't attributable to the business and are a sale of real property, then they are excludable, as long as the transaction is not sourced to the United States. Sales of real property are sourced where the transaction physically takes place... but the IRS literally has no opinion on where that is for sales of downloadable software. (I asked. They said "Write up your reasoning with your tax form. If we don't bill you, you're good.") If they are not real property, they may be a sale of computer licenses, which are arguably a source of royalties, which could be subject to a US/Japan tax treaty provision which overrides some of these rules but not others.
The above is not tax advice. Don't even ask about the Japanese side -- I have a few more weeks to figure that mind-meltingness yet.