What we call the income splitting strategy basically relates to a strategy that is frequently recommended by an accountant to save on employment taxes.
Employment taxes are primarily your FICA, namely Social Security, Medicare, and Medicaid. For the self employed employment taxes amount to 15.3% on every dollar you pay yourself all the way up to approximately $87,000. We say approximately here only because it changes every year. See 42 USC 430. In 2003 the wage base on which the Social Security portion of your wages is calculated is $87,000. Medicare and Medicaid are calculated on all of your wages.
The income splitting strategy is based on the principle that if you earn less wages then you pay less in employment taxes. The strategy for paying yourself less in wages while still paying yourself the same amount (or more) in cash involves characterizing a portion of your wages as a "distribution" which is analogous to a dividend.
When you receive a dividend from a publicly traded company you owe income taxes but not employment taxes on the amount received. This is because you did not earn the dividend as a result of "employment" so employment taxes are not levied. In tax terminology income that you earn as a result of rendering services is "earned income" and income that you earn as a result of investment capital at risk is "unearned income". Earned income is subject to employment taxes. Unearned income is not subject to employment taxes. Wages is a type of earned income. Corporate dividends are a type of unearned income.
If you own the company you can pay yourself wages or distributions. By adjusting the amount you pay yourself in wages and paying the remaining available profits to yourself as a distributions you may be able to substantially lower your overall employment tax burden.
When considering the income splitting strategy it is necessary to weigh the reasonableness of the salary or wages you pay yourself and the reasonableness of the distributions you make from the corporation. If you work for your corporation full time, have a college degree, and people doing what you do for other companies make $100,000, it will not be reasonable for you to pay yourself $20,000 and call the rest distributions. On the other hand, if you provide only part time services to an entity that you own, and your capital invested in the entity is very significant then it may be quite reasonable for you to take large sums as distributions from your corporation while paying yourself a relatively small salary. Some examples may illustrate this "reasonableness" calculus.
Assume you purchase a small submarine sandwich making franchised restaurant for $70,000. The previous owner was not taking a salary but was working at the restaurant full time, paying a manager $30,000 annually, and was breaking even. You manage the restaurant effectively and increase sales making the restaurant profitable to the tune of $85,000 annually. You could pay out the entire $85,000 to yourself in salary and bonus but you would owe employment taxes on the full amount. Alternatively you could employ the income splitting strategy. If you pay yourself $40,000 annually that is arguably a reasonable salary given the previous manager's salary of $30,000. You would pay the remaining $45,000 to yourself in distributions. Because you have made the restaurant profitable you have increased its value. It might be worth let's say $200,000, a figure selected only for purposes of this example. The $200,000 is your investment capital at risk. If that investment capital is throwing off $45,000 in cash annually you are realizing a 22.5% return on your investment. That is a high return but given the risk involved and the nature of the business the Internal Revenue Service would probably agree that it is not unreasonable for you to earn that amount of money as unearned income and not pay employment taxes on that amount if declared and paid as distributions.
The foregoing example would not work if you are a professional service provider, such as a lawyer, netting $85,000 annually. The problem here would be that your income is directly traceable to your personal service, not any substantial capital at risk. Therefore most professional service providers would have to declare all or almost all of their income as earned income and pay employment taxes on it.
S Corporation vs. LLC
The income splitting strategy is well accepted in the world of S Corporations. Some accountants will say that you can execute the strategy with an S Corporation and not with a Limited Liability Company. The truth is that since the advent of the "check the box" regulations in the late 1990s there really should be no difference between S Corporations and LLCs. However, the Tax Court case law and other applicable precedent is much stronger for executing the income splitting strategy in an S Corporation as opposed to an LLC. Therefore the balance of the advice is still to form an S Corporation if you are planning on taking advantage of the strategy.
Passing the Audit
In some senses you can pay yourself whatever you want. You can declare all of your income to be distributions and play audit roulette. If the IRS never audits your returns you're fine. The real challenge is determining how aggressive to be, i.e. how much of your income to call a distribution, and still be able to pass muster during an IRS audit. How aggressive you will be depends on the nature of your business, the reasonableness of your salary, the amount of capital you have at risk in your corporation, the reasonableness of your return on investment from the capital at risk, your tolerance for risk, your accountant's advice, and your accountant's tolerance for risk. Determining the amount of distributions to pay to yourself is really done on a case by case basis and should only be done in conjunction with the considered professional advice of a Certified Public Accountant.
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