Pay Yourself! Ignoring S Corp Reasonable Compensation Has Big Consequences
S Corp reasonable compensation. Just reading those words, you’re nodding off already, right?
If you ignore reasonable compensation, though, it’s a red flag to the IRS. When you catch their attention (and odds are they will), they can audit you, make you pay big taxes, and hit you with big penalties, too.
Did that just wake you up?
What’s the Deal with This S Corp Stuff?
If you file a Schedule C return as a sole proprietor, you pay self-employment tax on all of your net earnings. Self-employment tax is 15.3 percent, and that’s on TOP of what you’re paying in income tax. (That 15.3 percent is basically both the employer half and employee half of Social Security and Medicare.)
When you’re just starting out in business for yourself, that tax bill can be a big shock. Not to mention a hardship if you haven’t planned for it.
Fortunately, there’s an option that can help you avoid paying all that tax. You can choose (or “elect”) to file your tax return as an S Corporation (or S Corp as most people call it). This is the so-called S-Corp “loophole,” though it’s a totally legit tax procedure.
What Do I Have to Do?
You may be (probably are) the only “employee” of your S Corp. But you still pay yourself a wage. A rough rule of thumb is that your wage should be around 50 percent of your net profit. You pay Social Security and Medicare taxes on those wages, of course. But the other 50 percent of your profit you can take as distributions. THAT you don’t have to pay Social Security and Medicare – or self-employment tax – on.
For example, if you made $100,000 in net profit, paid yourself $50,000 in wages and took $50,000 as distributions, that would mean $7,650 in self-employment tax you wouldn’t have to pay.
Sounds great, right! Why not take all the money out as distributions? Because tax law says you must pay yourself wages (compensation), and that compensation must be reasonable.
What Is S Corp Reasonable Compensation?
How do you figure out what “reasonable compensation” is? Well, it’s what a company in your particular industry would pay someone else to do the same job (or jobs) you do. Is it reasonable for you to pay yourself $10,000 a year when you work 40+ hours a week? Probably not.
Here’s an example of someone filing as an S Corp who didn’t pay reasonable compensation. A CPA (who definitely should have known better) paid himself an annual salary of $24,000. On top of that, he took $220,000 in distributions. He went through the wringer of an IRS audit, and this is what happened when he came out the other side: The IRS ruled that $175,000 of his distributions should have been paid as salary. He had to pay both the employer’s and employee’s shares of Social Security and Medicare on that $175,000. That amounted to $26,775. And the IRS also hit him with penalties for the same amount, for a total of $53,550. It would have been a lot cheaper to do it the right way.
Here at Andrews Accounting, we’ve had to resort to issuing 1099s to company owners who never paid themselves any salary (or any payroll taxes) during the year. Just to meet with compliance on our end.
Another consequence is having your S corporation status revoked. That means paying self-employment tax forevermore.
Set Things Up Right, and Stick to the Plan
S Corp reasonable compensation is only one detail of this tax strategy. Consult with your accountant (like us!) to set up your new business structure properly, and plan for taxes.
Links
While an S Corp election can save you money, here are 10 arguments against it.
Lastly, you can learn more about our services here!
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