Most corporation owners form S corporations to save money on taxes. However, to make the most out of S Corporations, paying yourself a reasonable salary is an intelligent tactic to follow. This blog will go over how you can slash taxes with a reasonable salary for an S corporation owner.
What Can You Obtain with a Reasonable Salary?
A reasonable salary may not seem appealing in plain sight; however, there are hidden benefits from having one as an S corporation owner. A reasonable salary can:
- Save you money on payroll taxes
- Allow splitting of more income
- Help you manage deductible losses
Save on Payroll Taxes
As a proprietor, if you pay yourself a reasonable salary, you’ll be able to save on self-employment taxes. For example, Simon operates as a proprietorship and pays $14,130 on self-employment taxes on a $100k income. But if Simon operates his business as an S corp and pays himself a reasonable income of $50k and takes $50k as a distribution, he’ll save $7,065 in self-employment taxes. Distributions don’t trigger self-employment taxes, which is why it’s a great idea to keep your salary reasonably low. However, don’t get carried away! If your salary is too low, you can face payroll tax penalties of up to 100%, as well as negligence penalties.
Splitting Income Saves You Money on Taxes
When it comes to the splitting income strategy, it usually involves giving stock to lower-tax-bracket relatives. This allows the family as a whole to save on tax money. For example, Simon has gifted 40% of his S corporation stock to his parents and his parents-in-law. If his corporation earns $200k and he takes a salary of $150k, his parents and in-laws receive $20k in their lowest tax brackets (50k in profits × 40%). If he takes a salary of 90k, his parents and in-laws receive $44k in their tax brackets ($110k in profits × 40%).
Manage Loss Deductions
The at-risk rules limit S Corporation owner’s tax deductions to the sum at risk. If an owner clashes with the at-risk rules, lowering a salary can reduce or eliminate the nondeductible loss.
Zero Salary Strategy is Out
The IRS has been regularly winning court cases against S corporations that were using the zero salary strategy. When the IRS discovered Joseph Grey, an accountant who advocated this strategy to his clients, they discovered a litigation gold mine. After him, the IRS has won 7 cases against S corporations paying a zero salary. The tax court ruled that zero salary was improper and that all distributions were to be taxed as a salary. Zero salary is not going to work, so we do not advise taking this route. Tax law says that as an S corp officer, you are an employee of your S corp for social security tax purposes. As an officer, you’re only exempted if:
- You don’t work for the corporation
- You neither receive nor are entitled to receive (directly or indirectly) any remuneration
Establish a Reasonable Salary
The IRS has not established a “reasonable salary” due to it being a complicated and time-consuming process. It is really difficult for the IRS to challenge you if you have a basis for a reasonable salary. It’s rare to see court cases where the owner is collecting a salary from the S corporation. However, the IRS has many low-hanging fruits in the zero-salary realm. Generally, you’ll find a wide variety of salaries that you can prove as reasonable. So if you’re aiming to save some money on employment taxes, you’ll want to have a reasonable salary in the low range that is not too extreme.
In the court, the definition of a reasonable salary is still undefined. Thus, gathering facts that support the salary is taken is the primary step to building proof of a reasonable salary. You can base yourself on numbers seen on trade surveys, headhunters, and job ads. Remember to document your proof as it serves as evidence at the time you made the decision of the salary. We hope this blog helped give you some knowledge on how you can slash taxes with a reasonable salary for an S corporation owner. At MFI Works, we know that tax-related topics can be complicated, so don’t hesitate to contact us if you have any questions. To schedule a free initial business strategy session, click here.
