Can S-corps can save on taxes by up to 2% over LLCs taxed like partnerships?

There is a trend among tax advisers pushing small business owners to being taxed as an s-corp. The final straw that seems to be pushing people over the top is that S-corps can reduce your taxes by up to 2% when compared to an LLC taxed as a partnership.

Basically the savings comes from how things are taxed in a partnership vs an s-corp. To over simplify all distributions are taxed at 2% less in s-corps than partnerships. Cool! Well not that simple, actually you need to split your s-corp distribution into a salary (which doesn’t get the 2% benefit) and a distribution (which does get a 2% benefit). And according to the IRS:

“S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.”

So some advisers are saying, don’t worry set your salary really low at $35k or $40k because you want to maximize your benefit and the IRS doesn’t have a bright line test for “reasonable compensation”.  Now there is no magic number, but the lower you set your “reasonable compensation” the more benefit you get from the 2% savings. The lower you set your “reasonable compensation” the more at risk you are for triggering a *gasp* audit of your taxes. Right now the risk of audit is really low, but I was never one to act based on the risk of getting audited.

What would I do? Well I picked to be an LLC taxed as a partnership, but that is a separate story. But if I had chosen s-cop, I might look at my consistent draw as a salary or think about what I would pay someone else to do my main job at my company – I probably would steer clear of the crazy low salaries. But that is me, my goal today was to get you enough information for you to make an informed decision. Like I said, tax advisers are pushing most people this way, and I’m fine with that…as long as you understand the benefits and the risks.