How to determine S-corp reasonable salary?
I'm a sole proprietor making about $200-250k a year. I'm getting killed with self-employment taxes. I'm thinking about forming an S-corp and paying myself a reasonable salary and distributing the rest through dividends (so it is exempt from SE taxes). How do you determine what is "reasonable"? Do I take the average salary that someone in my profession in my geographic area makes? Or would the IRS conclude that if I was making $200k+ a year before I went to S-corp that a "reasonable" salary would be $200k?
The business, btw, is entirely service oriented, so I can't really justify dividends as easily as businesses involving capital assets. Also, the average in my field is prob $70-80k, which means that if that's a "reasonable" salary, then after $88,200, I only save about 2.9% a year on the rest - which may be cancelled out with the costs and pain in the butt of having an S corp in California.
What do you think?
Your situation is a good example of the ?lack of clarity? in the tax law. First let me say that you should consult with a CPA who can look at your situation in detail and offer some concrete suggestions.
Here are some factors (but not all) considered by the IRS and courts to determine if shareholder-employee compensation is reasonable:
1.Compensation paid for similar positions in other companies. (This appears to be the primary consideration by the courts.)
2.Time spent performing services for the corporation.
3.Compensation paid by the corporation to the officer in prior years.
4.The shareholders background and experience.
5.The corporations financial condition. (A corporation is not expected to pay more shareholder-employee salary than it can afford or even any salary if it has losses.)
6.Comparing compensation to distributions and retained earnings. (Did you take the money out or leave it in the business as capital.)
The Treasury Inspector General for Tax Administration recently issued a report recommending the IRS be more aggressive in pursuing the question of reasonable compensation for corporate shareholder-employees. IRS auditors have now been instructed to look for S-corps that report ?low? shareholder-employee wages where in the past they were only looking for zero wages being reported. Recharacterization of income as wages requires an IRS audit and the IRS currently has a limited number of auditors.
One important small-business rule regarding corporations: Never put real estate into a corporation or equipment that you think you will later want to take out into a corporation.
However, lets look at your possible status and some possible alternatives:
1.As a sole proprietor-
a.) Salary is not an issue as a sole proprietor does not take a salary.
b.) You can stay as a sole proprietor and pay $10,899.60 in social security tax (max @ 6.2%) plus 2.9% medicare tax.
c.) You will pay Federal income taxes in the 10%, 15%, 25%, 28%, and 33% tax brackets.
d.) You could setup a SEP retirement account and save as much as 35.9% (tax in the 33% bracket plus the medicare tax of 2.9%) on the max contribution of $41,000 or a tax savings of maybe $14,719.
e.) Once the Federal and State taxes are paid you have the money with no strings attached.
2. As a C-corp-
a.) You can incorporate as a C-corp, however, as a one man service operation you will be classified as a ?Personal Service Corp? with all net income taxed at the fixed rate of 35%.
b.) The net income is of course after you have taken a ?reasonable salary? and deducted employee benefits that are not deductible as an S-corp. Example of deductible employee benefits would be health insurance for you and your family, medical reimbursement plan for expenses not covered by the insurance (drugs, deductibles, co-pays, medical equip, etc.), group term life insurance up to $50,000 coverage, etc.
c.) Reasonable salary is usually not a big issue in a C-corp as the officers want a reasonable salary so the C-corp gets a deduction on its taxes. Also, its one of the few ways to get the money out of the C-corp and is usually used to ?balance? the tax brackets between the owners personal taxes and the C-corp taxes to obtain the overall lowest tax brackets. As an example: If the owner has no other taxable income and the C-corp net taxable income is say $100,000, then the balance is to give the officer a salary of say $50,000? which he will pay tax at a 15% rate and the C-corp will pay only 15% on the first $50,000 of taxable income. Therefore the whole $100,000 is taxed at only 15% where if no salary was taken the C-corp would pay 15% on the first $50,000, 25% on the next $25,000, and 34% on the last $25,000 of the $100,000.
d.) If you are in a high personal tax bracket (33% or 35%) without considering the C-corp income and the intent is to maximize employee benefits and retirement contributions (knocking that C-corp income way down without it being taxable on your 1040 ) then a C-corp as a Personal Service Corp (35% tax rate) may still be your best option.
3.As a S-corp-
a.) Reasonable salary is a BIG issue as the IRS automatically suspects that you have elected the status just to avoid the self-employment tax. You have to be in a position on audit to prove that you are taking a reasonable salary and have other business reasons (other than SE tax) to justify your low salary. One weak reason might be to accumulate capital for expansion of your business assuming you do not distribute the money to yourself but leave it in the business.
b.) Generally, ?All? S-corp net income is taxable to the shareholders on a per share basis regardless of when the income is paid out. An S-corp does not pay ?dividends? (unless the payment is from retained earnings where the corp was previously a C-corp and paid taxes), rather it pays out the already taxed income as tax-free ?distributions?.
c.) If the S-corp does not distribute the income that you paid tax on, then the income retained in the business (the balance in the AAA account) becomes capital that deserves a reasonable return on profit and income not subject to self-employment earnings. Thus it becomes a factor in the calculation of income available for reasonable salary.
d.) Shareholder-employee benefits paid by the S-corp do not decrease S-corp taxable income, rather they pass thru as possible deductions for 1040 Sch-A as though they were incurred personally. example is health insurance.
e.) Some shareholders pay family members salaries to lower the S-corp?s net income and get money to family members in a lower tax bracket.
..........i.) Proposed Reg ? 1.1366-3 gives the IRS authority to challenge compensation paid to members of the family if the compensation is not reasonable for services performed.
..........ii) .If the child is under age 14 the income tax bracket for the child is the same as the max tax bracket of the parent and therefore is of no advantage.
*Clicks the "PRINT" button on yet another of OldJack's lessons, for later reference.*
After reading my post I realize that my answer was just as unclear as the law is unclear. Damn!
Well... I will stick my neck out and say that if you follow factor #1 and pay yourself a S-corp salary comparatively to others in your industry you can probably get by without a problem and save on SE tax. There.. I said what you wanted to hear. This is assuming that you are not so aggressive with other tax items that would cause your S-corp or 1040 tax return to be subject to audit anyway. Bye the way, the IRS always audits both S-corp and individual 1040 when the have reason to look at either one by itself. Lets face it, your tax return is "scored" at process time and the IRS has too many other returns to look at if yours shows a fairly good salary thereby not adding up much score.
my 2? ??
Damn! Can we all just hire OldJack?
Too bad you're in Missouri! Thank you, thank you, thank you!
You are most welcome. Why would anyone want to hire an old fart like me? Damn.. I got to watch my mouth, I forgot this is read by everyone!
Is this the "Tax Loophole" that John Kerry is talking about undoing? The reasonable salary and dividends thing... I heard this is the item that Dick Cheany and John Edwards were banttering about. During the Vice President debate, Cheany pointed out that Senator Edwards made a couple million in profit over this exact loophole the John's are trying to undo. As a business owner, undoing the reasonable salary and dividends law might mean the difference of a whole mess of money.
Best of Luck,
The reasonable salary and dividend thing is not really a loophole as the IRS is still getting taxes, just not as much as it might want. It is still as much as if there was no corporation. Let's face it, our government is greedy and wants more than any other partner would want considering they do nothing to help you earn it.
I don't think this is what Kerry had in mind as he didn't seem to know what a Subchapter S corporation was when Bush pointed out that most small businesses pay income taxes at the higher individual tax brackets that Kerry was saying were the wealthy. The shareholder pays the tax (as though they were wealthy) but has to leave the money in the corporation to hire employees and grow the business.
I don't think Kerry ever saw a tax that he didn't like and I don't think there is any doubt that if he becomes president every american's taxes will go up. Kerry is nothing but a voice blowing in the wind and if he wins it will be the biggest scam of the public ever. Maybe we deserve it as he is just tell us what we want to hear.
Bush is correct that taxing small business at such a high tax rate simply keeps small business without the capital needed to hire employees and to grow.
I am not sure just what tax Kerry is talking about (flip-flop) regarding closing loopholes except that he is correct that something has to be done to discourage exporting jobs to other countries.
Kerry talks about being realistic? I don't think Kerry has a clue when it comes to taxes for the average american or small business. The child credits he offered in the last debate sounded to me like the same child credits Bush already has passed into law and we took on our 2003 tax returns.
In my opinion the current income tax law should be scrapped and start over with some other way to raise revenue for government. Why should every american have to go through this mental masterbation every year!
just my 2? ??
Originally Posted by OldJack
I saw this line and had a quick question. Does the money have to be left in the corporation? I mean, yeah, to some extent, some money needs to be there, but the surplus can be distributed, right?
Are there strict regulations on how much can be distributed?
Another question came to mind, where does the money end up from an accounting standpoint? Since S Corporations do not have Retained Earnings, what is the accounting for the money left in?
The shareholders have paid 1040 tax on the S-corp profits regardless of the timing of the cash distributions, so the money belongs to the shareholders and may be taken out tax-free at any time or be left in the corp as operating capital to be taken out when not needed.
Money left in the corp helps supports the argument that the business needs operating capital (if it does) and therefore can't afford the payment of high salary to a working shareholder. It further supports the argument that a part of the cash distributions are a reasonable return on capital investment not subject to reclassification as wages and therefore not subject to self-employment tax.
Money left in the S-corp is in the bank account and in some equity account usually referred to as the "AAA Account". The AAA account (Accumulated Adjustments Account) is a retained earnings account with a different name to simply identify that the income tax has already been paid on the account by the 1040 shareholder. Some financial statement preparers may just show it as retained earnings as it truly is retained earnings, just not taxable on distribution. If you look at the S-corp tax return, 1120s, page 4, line 24, it is called "Retained Earnings" and the balance you will report on that line will be the balance of the "AAA account" from 1120s, page 4, Schedule M-2, line 8a. So the AAA account is a "part" of the overall retained earnings account if the S-corp was previously a C-corp with previous retained earnings.
The surplus "AAA account" may be distributed in full tax-free. If you distribute more than the AAA account, then if the business was previously a C-corp you are distributing taxable retained earnings (taxable dividends) . If there were no previous C-corp earnings, then you are distributing non-taxable stock basis (return capital investment), if there is no stock basis, then you are distributing taxable capital gains treated as from sale of property.
As to the question of "reasonable salary", it is clearly a "facts and circumstances" question. If you have not paid a reasonable salary and distribute all the cash as tax-free distributions, it becomes obvious that your purpose is to avoid self-employment tax. Some factors considered by the IRS and courts to determine if shareholder compensation is reasonable:
1) Compensation paid for similar positions in other companies.
2) Shareholder's background and experience.
3) Time spent performing services.
4) Salary paid to other employees.
5) The business financial condition. (If the business has little profit then it can't afford much shareholder salary.)
6) Compensation paid in prior years.
7) Comparing compensation to distributions and retained earnings. (If the business has large cash distributions from profits, then why no salary being paid?)
So far, the IRS has primarily been auditing only those S-corps that show no salary paid to officer/shareholders.