âThe pigs are getting fat, the pigs are slaughtered. In life and taxation.
S-Corps are great entities for saving self-employment taxes, but with those savings comes a little extra annual work. One of the year-end tasks is to determine and pay reasonable compensation to the owners of the S-Corp.
Why should you consider reasonable compensation every year? First of all, one factor that the IRS will take into consideration is the profit of the business. Second, the type of work you do for the business has probably changed as well.
How can an S-Corp save me taxes?
All LLC income is taxed as wage income to 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 health insurance. While the 12.4% ends at $ 142,800 in 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 salaries over $ 200,000 for single taxpayers and over $ 250,000 for married taxpayers filing jointly. Payroll taxes are in addition to federal and state income taxes you pay on your income. This is a separate additional tax.
S-Corps owners can receive “reasonable” compensation for their services and receive their share of the remaining income in the form of a distribution. The remuneration portion will be subject to payroll taxes, but not distributions. 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 likes to audit S-Corp owners to see how much they paid themselves in wages versus distributions.
What the IRS says
As we begin this discussion, please refer to the quote at the top of the page. If you take a reasonable approach to S-Corp compensation, you can save taxes and avoid trouble with the IRS.
Reasonable compensation is a hotly debated topic and the IRS hasn’t given many rules to stick to. This creates opportunities and potential pitfalls. Below are some of the determining factors the IRS will look at in determining if your compensation is reasonable:
– Training and experience
– Duties and responsibilities
– Time and effort devoted to the company
– Dividend history
– Payments to non-shareholder employees
– Time and method of payment of premiums
– Comparable compensation
– Agreements and remuneration formulas.
The IRS will begin its analysis by examining how your S-corp made its money. There are three main sources of gross revenue:
1. Shareholder services
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 off you have to pay less money as compensation. Your business that makes money without your direct effort increases the value of your business and can reduce what you pay in self-employment taxes – double the payoff.
Where to start?
As the leader of your organization, you will have a good idea of ââwhat you would have to pay a non-owner to do the work you do. This amount would be an excellent starting point for reasonable compensation. Use the same tools you use to determine reasonable compensation for your employees for your work.
Remember that you are probably doing a lot of work in your business that would be paid differently. You could do professional jobs, janitorial, bookkeeping, secretarial work, and a host of other jobs. How much time do you spend on each type of job and what would be a reasonable salary for that job?
Rule of 1/3: Another simple measure to start the discussion on reasonable compensation is the ârule of 1/3â. This rule comes from professional service organizations where the goal is to charge at least 3 times an employee’s salary. 1/3 of what you bill pays the employee. 1/3 pays overhead and 1/3 provides return on investment for business owners.
If you are going through this process for yourself, document the sources you used to determine your reasonable compensation plan. I strongly suggest that you discuss this with your CPA. They’ll know the right questions to ask and can help you leverage your industry knowledge to develop a compensation strategy.
If you want solid documentation for IRS appeals, have your CPA have a compensation analysis done by a company like RC Reports. They can provide a lot of good data for your case at a reasonable cost.
If you are an entrepreneur, focus on building a great and profitable business. Work with your CPA to minimize your taxes and risks.
Disclaimer: Please don’t take this as tax advice, but let it inspire you to have better discussions with your CPA.
We love helping executives build great businesses, and we have some great free resources for you in our Resource Library. You can view them at: www.valuesdrivenresults.com/resource-library/ or call us at (229) 244-1559. We would be happy to help you in any way we can.
Curt Fowler is President of Fowler & Company and Director of Fowler, Holley, Rambo & Stalvey.
Curt and the team at FHRS help executives build great companies with split CFO, strategy, tax and accounting services.
Curt is a business writer, keynote speaker, and business advisor. He holds an MBA in Strategy and Entrepreneurship from the Kellogg School, is a CPA, and a great guy as defined by his wife and five children. (Welcome Baby Owen – June 2021!)