For regular C corporations, “reasonable compensation” can be a troublesome tax issue. The IRS doesn’t want shareholder executives to inflate their deductible salaries while minimizing the corporation’s nondeductible dividend payouts. For S corporation owners, the opposite is true. If owner employees take what the IRS considers “unreasonably low” compensation, the IRS may recast the earnings to reflect higher payroll taxes, along with interest and penalties.
One pocket to pick
Eligible corporations that elect S status avoid corporate income taxes. Instead, all income flows through to the shareholders’ personal tax returns. Example 1: Ivan Nelson owns a plumbing supply firm structured as an S corporation. Ivan’s salary is $250,000 a year while the company’s profits are $400,000. The $650,000 total is reported on Ivan’s personal tax return. In 2014, Ivan pays 12.4% as the employer and employee shares of Social Security tax on $117,000 of earnings. He also pays 2.9% Medicare tax on his $250,000 of salary. As a result of recent tax legislation, Ivan—who is not married—owes an additional 0.9% Medicare tax on $50,000, the amount over the $200,000 earnings threshold (the threshold is $250,000 on a joint tax return). Altogether, Ivan pays well over $20,000 in these payroll taxes.
Often, S corporation owners have a great deal of leeway in determining their salary and any bonus. Holding down these earnings may reduce payroll taxes. Example 2: Jenny Maxwell owns an electrical supply firm across the street from Ivan’s business. Jenny’s company also is an S corporation. She reports the same $650,000 of income from the business but Jenny classes only $75,000 as salary and $575,000 as profits from the business. Thus, she pays thousands of dollars less than Ivan pays for Social Security and Medicare taxes.
Proving your payout
As mentioned, the IRS might target S corporation owners suspected of lowballing earned income. Therefore, all S corporation shareholders should take steps to justify the reasonableness of their compensation. If you own an S corporation, consider spelling out your salary level in your corporate minutes. Where possible, give examples and quote industry statistics that show your compensation is in line with the amounts paid to executives at similar firms. Other explanations also might help. Depending on the situation, you might say that business is slow, in the current economy, so the minutes will report that you are keeping your salary low to provide working capital for the company. If your business is young, the minutes could explain that you’re holding fixed costs down, so the company can grow, but you expect to earn more in the future. In still another scenario, you might say that you are nearing retirement and making an effort to rely more on valued employees, so a modest level of earnings reflects the actual work you’re now contributing. As illustrated above, holding down S corporation compensation can result in sizable payroll tax savings. Our office can help you establish a reasonable, tax-efficient plan for your salary and bonus.
Beyond compensation, health insurance also may affect the payroll tax paid by an S corporation owner. Special rules apply to anyone owning more than 2% of the company’s stock. If the company has a health plan and pays some or all of the costs for coverage of such a so-called “2% shareholder,” the payments will be reported to the IRS as taxable income. However, that amount will not be subject to payroll taxes, including those for Medicare and Social Security. The company can take a deduction for these payments, effectively reducing corporate profits passed through as taxable income for the shareholder. In addition, the S corporation shareholder may be able to deduct the premiums paid by the company—this deduction can be taken on page 1 of his or her personal tax return, which may provide other tax benefits. However, such an “above-the-line” deduction cannot be taken in any month when the shareholder or spouse is eligible to participate in another employer-sponsored health plan. Also, this deduction can’t exceed the amount of the shareholder’s earned income for the year. This can be a complicated issue, especially if your state law prevents a corporation from buying group health insurance for a single employee. If you own an S corporation, our office can help you decide the best way to hold down payroll tax as well as income tax from your health plan.