Businesses that have incorporated are taxed one of two ways. A “C” corporation pays its own income tax. An “S” corporation’s income flows through to the stockholder’s tax return and the stockholder pays the tax on his or her pro-rata share of the S corporation income. If a stockholder also works in the business, he or she will be an employee of the corporation. If you are both a stockholder and an employee of the corporation, how much should you pay yourself?
If you are the sole or a major stockholder in an “S” corporation you are motivated to set your salary low to minimize the employment taxes. If you need to take additional money from the “S” corporation, you take the money as a distribution because distributions are not subject to employment taxes. If you are a stockholder of a “C” corporation you are motivated to set your salary high to avoid the potential double taxation of the company’s earnings.
Many small businesses will incorporate and elect to be taxed as an “S” corporation with their primary purpose of reducing the amount paid in self-employment tax. How does this work?
Let’s assume that you own a business that has a profit of $90,000. You are the sole owner of the business and the business is not incorporated. In addition to income tax, these earnings are subject to self-employment tax. When you file your income tax return, you will have to calculate how much self-employment tax you will have to pay for the year. Self-employment tax is calculated my multiplying the business’ profit by the self-employment tax rate of 15.3%. In our illustration your net earnings are $90,000. The self-employment tax on $90,000 is $13,770 [$90,000 X .153]. This is in addition to your income tax!
Let’s compare the above illustration to how this profit might be treated in an “S” corporation. Unlike the proprietor’s profit, the earnings of “S” corporations are not subject to self-employment tax. So the self-employment tax on the “S” corporation earnings is $0. WOW! That’s a savings of $13,770! That’s huge (for many small business owners)! --- Don’t you wish life was that simple? It’s not. Why?
Remember, if you work in the business you are an employee of the corporation. If you don’t pay yourself any compensation subject to employment tax, the IRS has the authority to re-characterize all the distributions the ‘S” corporation paid you as wages subject to employment taxes. It’s prudent as an employee-shareholder of an “S” corporation to pay himself or herself salary or wages. But how much?
Historically, the IRS has challenged the owner/employees of “C” corporations for paying themselves too high a salary and re-characterizing part of the salary as dividends. This is because dividends are not deductible by the corporation and they are taxable income to the owner/employee. This results in an increase in tax for both the corporation and the individual. Most of the factors the IRS and the courts use to determine whether a salary is reasonable where developed in this “C” corporation context. However, these same factors are applicable when determining if the compensation of the “S” corporation owner/employee is too low.
The IRS will not give you an advance ruling as to whether a certain level of compensation is reasonable. The IRS says a reasonable salary is the amount that would be paid by a similar company for providing similar services under similar conditions. This is ambiguous by any account, but the ambiguity can be to your advantage. Depending on your circumstances, by setting you compensation reasonably low, an “S” corporation employee/stockholder can still pay less in employment taxes and avoid IRS challenges. Inversely, the “C” corporation employee/stockholder and pay him or herself reasonably high compensation and avoid some of the double taxation issues. Reasonable compensation will always be within a range, not an exact total. Your challenge, if you want to minimize the employment taxes, will to always be on the low end of the reasonable range. Your challenge as a “C” corporation owner/employee, if you want to keep from being double taxed on the same earnings, will be to set your compensation on the high end of the range.
Factors used by the courts in determining reasonable compensation include (but not all inclusive):
- your qualifications,
- the nature, extent and scope of your work,
- the size and complexities of the business,
- comparison of the salaries paid with the gross income and the net income,
- the prevailing general economic conditions,
- comparison of salaries with distributions to stockholders,
- the prevailing rates of compensation for comparable positions,
- the salary policy of the taxpayer as to all employees, and
- the amount of compensation paid to the particular employee in previous years.
The factors above have to be considered together. Not any one is determinative. So anyway you look at it, setting yourself a reasonable salary is a judgment call. How high or low you set your salary will be affected by your risk tolerance level and your fear of the IRS. My advice? Be reasonable.
[Note: To get a baseline of what might be reasonable compensation, consult an online service like Salary.com. Salary.com will let you search by job title and zip code and provide you with a range for base salary, bonuses, and benefits for free.]
