I have a solo/small law firm in NYC. We incorporated as an LLC. People have been telling me I can partially avoid the self employment tax, if I issue myself a reasonable salary and pay any excess in dividends. Is this true?
Let me preface by saying that a single member LLC is a disregarded entity for tax purposes. You will file as a sole prop on a Schedule C, and all of the income will be subject to self-employment taxes. So the rest of the explanation is pretty much a moot point, but I will give it anyway.
A single member S corporation is respected, but I think the savings really applies to people in other types of business. What a reasonable salary for an attorney? How much did you make before you went solo? They are going to look at many factors to determine what is a reasonable salary. Too many people think $60,000 is a reasonable salary for anybody, but the IRS will not see it that way. And honestly, if you really are the only attorney there, and only your services produce revenue, the IRS will claim a reasonable salary is exactly what you pull in being a solo practitioner.
Your plan to reduce self-employment tax works with business S corporations, but not with single-member LLCs. The theory is that part of the corp’s income arises from the invested capital and part of it from the entrepreneur’s services. So a salary is paid for the latter element and the rest is deemed return on investment. So the other commenter’s point is that capital has little to do with a law firm’s earnings.
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(Bryant) Keith Martin
This strategy my work if your LLC has elected to be a Sub Chapter S Corp because this a Sub S tax strategy. Otherwise attorney Larson is correct it does not apply to SMLLC's.
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An LLC can elect to be taxed as an S corporation, and I do not believe that single member LLC's are excluded. However, as my accountant advises, if you want to be taxed as an S corporation, why not be an S corporation rather than an LLC.
Unfortunately, LLC's have become the darling of entrepreneurs and they are not always the best option. So, you can elect to be taxed as an S corporation or convert to an S corporation. Then you pay yourself a salary reasonable for the work done and the industry you are in. For example, if you are developing software, you must pay yourself in all likelihood more thatn $85,000 annually. Then the difference between your salary and $106,800 is not subject to the 15.3% FICA tax. The amount over $106,800 is not subject to Medicare tax. Your accountant can guide you.
Caution - as pointed out earlier - your particular industry makes the SMLLC - S-Corporation strategy of paying yourself a smaller salary to avoid employment taxes very, very, very risky. The IRS is already on an all out war against this strategy to begin with. Combine this with the fact that you are the sole manager of the business (law firm) and it would be hard to argue that you shouldn't get a salary equal to the profits.
You keep hearing about it because it has been a viable strategy in the past decade. It has been one of those exploited loopholes, as everyone calls it. But it is very close to the end of it's day and you would very likely be setting yourself up for an audit.
I hope this helps answer your question and dis-wades you from going forward with the idea.