Ask most people why they want to operate their business as an S corporation and the most common answer you’ll get is they want to save on self-employment taxes. With payroll taxes increasing in 2013 due to new legislation impacting social security contributions and the 0.9% Medicare surtax on income over $200,000 ($250,000 for married couples), it’s no surprise an S Corp is an attractive option.
That begs the question though: What salary are you going to take from the S corporation?
Now, this is where things get complicated. If the salary is too low, the IRS hammers you with payroll tax penalties. If the salary is too high, you cheat yourself of tax savings.
To see how complicated salary planning for an S corporation can be, let’s take look at a real tax court case involving a CPA practice run by a single owner. In this case, the S corporation’s net earnings for the year were $246,000. How much salary should the owner of this S corporation take?
1. $20,000 (that’s what one owner actually took)
2. $246,000 (the law is going to make the owner take all the earnings as salary)
3. $176,000 (that’s the average earnings from corporations like this one)
4. $91,000 (this is the salary that would be paid to a high-level staff person enhanced by the additional billing rate percentage of a partner).
The correct answer is $91,000.
In a case involving a CPA running his own practice, the IRS expert actually agreed that a salary of $91,000 was reasonable compensation. He did this by consulting the Management of an Accounting Practice (MAP) survey that is conducted by the American Institute of Certified Public Accountants.
The MAP survey showed that owner-employees like the CPA in this example would receive approximately $176,000 annually in combined compensation and return on investment.
To determine the salary portion, the IRS expert found that a director (an employee with no ownership interest) would earn $70,000 a year. Since owners billed at rates 33 percent higher than directors, the IRS expert took the $70,000 and enhanced it by 33 percent and then made a couple of other minor adjustments to arrive at the $91,000 salary.
This example shows that the S corporation provides salary planning opportunities that allow owners to minimize their payroll taxes. The key, however, is to keep good evidence of why your salary, as low as it might be, is considered a reasonable salary.