Final answer:
Lenny's salary from the S corporation is subject to payroll taxes (Social Security and Medicare), but the distribution of profits is not. He must report the profits on his personal income tax return and is taxed regardless of actual distributions. Lenny must also ensure his salary is reasonable for the services he provides to avoid IRS scrutiny. Option first is the correct answer.
Step-by-step explanation:
Lenny, the sole shareholder of an S corporation who draws both a salary and distribution of profits from the corporation, is subject to different taxation rules for each source of income. His salary is subject to payroll taxes which include Social Security and Medicare taxes, with the rates for these taxes being split between the employer and employee. However, if Lenny were self-employed and received a 1099 tax statement, he would be required to pay both the employee and employer portions of these taxes.
On the other hand, the profits Lenny receives, known as distributions, are not subject to payroll taxes. Instead, these profits are reported on his personal income tax return and taxed at his individual income tax rate. It is incorrect to think that he will only pay taxes on the portion of profits he physically distributes to himself; as an S corporation shareholder, he is taxed on his share of the corporation's income regardless of whether it is distributed.
Additionally, the notion of setting a salary based solely on tax benefits without consideration of what is reasonable in the market can attract scrutiny from the IRS. Lenny must pay himself a reasonable salary for the work he does within the corporation, which is considered a deductible business expense for the corporation and is also subject to income and payroll taxes on Lenny's end.
Considering this information, the statement that Lenny's share of the profits will not be subject to Social Security or Medicare taxes is correct.