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 Corporation
With a Subchapter S corporation, income earned by the owner from the business is generally not subject to self-employment taxes. Instead, the income may constitute taxable wages or a distribution of profits to the owner. The wages will be subject to payroll taxes that are the equivalent to self-employment taxes. The profits distributed to the owner will not be subject to this tax. This is one of the basic tax benefits of using a Subchapter S corporation.
The question presented in Jarrett v. Commissioner, T.C. Summary Opinion 2008-94, 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.
Facts & Procedural In Jarrett’s Case
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. 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 in 1999. 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, the IRS disallowed the $7,000 deduction and to include 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.
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.
Jarrett probably could not take advantage of the normal arrangement of operating his business using just a Subchapter S corporation in an effort to lower his payroll tax liability. The amount of money that he earned during the year does not appear to be sufficient for the Subchapter S corporation to pay a reasonable wage and then have some amount of profits left over to pay him a distribution of the profits. All of the $7,000 may have constituted wages to Jarrett.
Given the facts described in the court option, it appears that Jarrett may have tried to sidestep this problem by having his sole proprietorship pay the Subchapter S corporation and then claiming a deduction for the payment, thereby reducing his self-employment taxes for his sole proprietorship rather than reducing his payroll taxes using just a Subchapter S corporation.
Notwithstanding the nominal amounts involved, it seems as if this type of transaction would not result in any significant tax savings. The amounts paid to the Subchapter S corporation probably should have been paid as wages to Jarrett and they would have been subject to payroll taxes. This might be different if the payment was for an activity in which Jarrett did not have to perform services or where the services of the Subchapter S corporation were provided by an independent contractor engaged by the Subchapter S corporation to provide services to the sole proprietorship.