âThe pigs are getting fat, the pigs are slaughtered. In life and taxation.
S-Corporations are a great choice of entity for businesses that make a lot of money. If you’re just getting started, an LLC may be a simpler alternative that you can convert to an S-Corp once the tax savings justify the move.
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.
Payroll taxes are in addition to federal and state income taxes you pay on your income. It’s a separate tax that many entrepreneurs don’t pay enough attention to, which is quite a good thing. As an entrepreneur, your goal should be to make money, but make sure you hire a great CPA who will take care of the taxes for you.
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 is a reasonable salary?
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. Here are some of the determining factors the IRS will look at in determining if your compensation is reasonable:
– Training and experience.
– Duties and responsibilities.
– The time and effort devoted to the business.
– Dividend history.
– Payments to employees who are not shareholders.
– Time and method of payment of premiums.
– Comparable remuneration.
– Agreements and remuneration formulas.
How do I determine a reasonable remuneration for me?
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 a reasonable compensation.
Hope this is less than 100% of what you pay yourself. If it’s 100%, you don’t have a business, you have a very stressful job.
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 interesting 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 tax liability 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 leaders build great businesses, and we have some great free resources for you in our Resource Library. You can view them here -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 businesses through virtual 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 Kellogg School, is a CPA, and a pretty good guy as defined by his wife and four kids (# 5 coming June 2021!).