Under Subchapter S of the Internal Revenue Code, qualifying corporations can elect S corporation status, which allows the corporation to be treated as a flow-through entity for income tax purposes. This means that the income, deductions, and other tax attributes of the corporation flow through to the shareholders, who report corporate earnings on their individual tax returns. While this may seem insignificant, self-employed individuals can realize huge tax savings by operating as an S corporation.
Here's how it works:
The earnings of an S corporation can be allocated to shareholders in one of two ways: (1) as salary; or (2) as a distribution of profit.
Significantly, any amounts in excess of salary (i.e. distributions of profit) are not subject to FICA (Social Security) or Medicare taxes.
Therefore, self-employed individuals can partially opt out of the 12.4% FICA (Social Security) tax (on first $106,800 of salary) and the 2.9% Medicare tax to the extent that earnings are classified as a distribution of profit (rather than as salary).
As an example, consider a personal trainer who opens a personal training studio. Let's say that after paying all expenses, our trainer earns $100,000 during 2011. If the entire $100,000 is paid out as salary, the trainer will pay $15,300 in payroll taxes. ($12,400 FICA (Social Security) tax; $2,900 Medicare tax).
If, instead, $53,323, which is the average salary for a certified personal trainer according to the American Council of Exercise, is classified as salary and the remaining $46,677 is classified as a distribution of profit, the trainer will pay $8,158 in payroll taxes ($6612 FICA (Social Security); $1,546 Medicare). This amounts to payroll tax savings of $7,142, or 46.6%!
This loophole is popularly referred to as the "Edwards gambit," named after American attorney and politician, John Edwards, who notoriously avoided more than $500,000 in Medicare tax by employing the Subchapter S corporate structure for his law firm. In the four years before becoming a U.S. Senator, Edwards earned some $27 million as a personal injury lawyer. Of this $27 million, he classified about $1.5 million as salary and the remaining $25.5 million or so as a distribution of profit. In this way, he avoided paying Medicare tax on more than $25.5 million of earnings and saved $591,112.
To be sure, Edwards' tax avoidance tactic was widely criticized by political adversaries as evasive and deceptive. But the fact is that this tax avoidance strategy, when employed in a reasonable and non-abusive manner, remains permissible under the current tax law. So, don't hate the player, hate the game.