Monday October 26, 2015
As a business owner, you have probably thought to yourself: how do I receive the profits from my company and pay the least amount of taxes on my hard earned profits?
If you have a S-Corp there are two ways to receive your profits:
(1) Pay yourself a salary
(2) Pay yourself with distributions
Sadly, there is a large difference between these two option:
A salary is subject to employment taxes (usually around 15%) and the all too familiar payroll-related taxes (withholding, Medicare, etc.).
In contrast, a distribution is tax-tree and as quick and easy as the business writing a check.
So why not forget about the salary all together and just pay with distributions? The IRS knows business owners don't like paying taxes and argue that no one works for free and therefore you must pay yourself and the related taxes. The IRS created rules to regulate business owners. These rules are called "Unreasonable compensation".
When we see the term "Unreasonable Compensation", most of us think about large public company executives who are paying themselves way to much and buying boats, cars, jets, and helicopters.
But the term "unreasonable compensation" applies to both C-Corps and S-Corps. The situation explained above relates to C-Corporations, in which the IRS is watching to make sure owner-employees are not paying themselves too much.
But the IRS is watching your compensation for S-Corps too:
They are looking for the exact opposite: if your wages too low, this is a red flag to the IRS. "Compensations of officers" is line 7, right smack in the middle of the front page of your 1120s U.S Income Tax Return for an S Corporation.
Here are some red flags to make sure you are not doing:
(1) Salary is zero
(2) Salary that is not reasonable (for Example, $15,000 is not a adequate salary for all the hours you work, stress you endure or in comparison with what you pay your employees)
(3) The 60/40 Rule: salary should never be less than distributions. Salary should be around 60% of profits, where as distributions should be around 40%.
(4) Distributions are based on ownership percentage: if there are two 50/50 owners who have $100,000 in profits, they should each (after salaries) get $50,000.
(5) Distributions should never exceed the profits for the year.
What you need to know about the “S” Corporation Election
If the IRS determines that the owners (two or more shareholder-employees) have been paid unreasonably low compensation...
Here may be the consequences from the IRS:
- Involuntary revocation of the “S” election
- Required additional payroll tax, penalties, and interest at the federal level
- Additional taxes, penalties, and interest
- Additional state payroll taxes; unemployment taxes; workers compensation insurance and their associated penalties and interest
- The IRS usually looks at 2-3 years at a time, which means all these costs times 2 or 3.
It's not a pretty thing if the IRS challenges your S-Corp officer compensation. Save yourself the headache and money by talking to Laura about what your S-Corp owner-employee wages should be to avoid an IRS challenge.