“Pigs get fat, hogs get slaughtered. In life and taxation.”
S-Corps are great entities to save self-employment taxes but those savings come with a little extra yearly work. One of the end of year tasks is to determine and pay a reasonable compensation to owners of the S-Corp.
Why should you consider reasonable compensation every year? First, a factor that the IRS will consider is the profit of the company. Second, the type of work you do for the company probably changed as well.
How Can An S-Corp Save Me Tax Dollars?
All income from LLCs is taxed as wage income to the owners and subject to payroll taxes. In 2021, payroll taxes are 15.3% on the first $142,800 of taxable income. 15.3% is the combination of 12.4% for Social Security and 2.9% for Medicare. While the 12.4% stops at $142,800 of income in 2021, there is no limit on income subject to the 2.9% Medicare tax.
There is also the Additional Medicare Tax charged at 0.9% on wages above $200,000 for single tax payers and above $250,000 for married filing jointly taxpayers. Payroll taxes are in addition to federal and state income taxes that you pay on your income. It’s a separate, additional tax.
Owners of S-Corps can be paid “reasonable” compensation for their services and receive their portion of the remaining income as a distribution. The compensation portion will be subject to payroll taxes, but the distributions will not. This can be a big win for business owners. S-Corps are also not subject to double taxation like C-Corporations.
This is why the IRS loves to audit S-Corp owners to challenge how much they paid themselves in salary vs. distributions.
What the IRS Says
As we start this discussion, please refer to the quote at the top of the page. If you’ll take a reasonable approach to S-Corp compensation you can save taxes and stay out of trouble with the IRS.
Reasonable compensation is a highly debated topic and the IRS has not given a lot of rules to stand on. This creates opportunities and potential pitfalls. Below are some of the determining factors the IRS will look at when determining if your compensation is reasonable:
– Training and experience
– Duties and responsibilities
– Time and effort devoted to the business
– Dividend history
– Payments to non-shareholder employees
– Timing and manner of bonuses paid
– Comparable compensation
– Compensation agreements and formulas.
The IRS will start its analysis by looking at how your S-corp made its money. There are three primary sources of gross receipts:
1. Services of the shareholder
2. Services of non-shareholder employees or
3. Capital and Equipment
The more money your business can make without you doing the work the better case you have for paying less of the cash out as compensation. Your business making money without your direct effort increases the value of your business and can reduce what you pay in self-employment taxes – a double win.
Where to Start?
As the leader of your organization, you will have a good idea of what you would have to pay a non-owner to do the work you do. That amount would be a great starting point for reasonable compensation. Use the same tools you use to determine reasonable compensation for your employees for your job.
Remember that you probably do lots of jobs in your business that would be paid different wages. You might do professional, janitorial, bookkeeping, secretarial, and a host of other work. How much time do you spend on each type of work and what would a reasonable wage be for that work?
Rule of 1/3: Another simple metric to start the reasonable compensation discussion is the “rule of 1/3.” This rule comes from professional services organizations where the goal is to bill at least 3x an employee’s salary. 1/3 of what you bill pays the employee. 1/3 pays for overhead and 1/3 provides a return on investment to the business owners.
If you are working through this process for yourself, document the sources you used to determine your reasonable compensation plan. I highly suggest you discuss this with your CPA. They will know the right questions to ask and can help you leverage your industry knowledge to come up with a compensation strategy.
If you want strong documentation for when the IRS calls, talk to your CPA about getting a compensation analysis done by a firm like RC Reports. They can provide a lot of great data to make your case at a reasonable cost.
If you are an entrepreneur, keep your focus on building a great, profitable business. Work with your CPA to minimize your tax liability and risk.
Disclaimer: Please do not take this as tax advice, but let it spur you to have better discussions with your CPA.
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Curt Fowler is president of Fowler & Company and director at Fowler, Holley, Rambo & Stalvey.
Curt and the team at FHRS help leaders build great companies through Fractional CFO, strategy, tax and accounting services.
Curt is a syndicated business writer, keynote speaker, and business advisor. He has an MBA in strategy and entrepreneurship from the Kellogg School, is a CPA, and a pretty good guy as defined by his wife and five children. (Welcome Baby Owen – June 2021!)