This is How To Reduce Taxes for S Corporation Owners

October 1st, 2014 at 12:29 PM

If you are operating as an S Corporation, your salary is a key element to an excellent tax reduction strategy.

The lower your salary, the more you save in payroll taxes.

However, if you set your salary too low, the IRS may, upon audit, step in and re-characterize as higher; that would result in additional taxes, penalties, and interest charges—ouch!

Therefore, you need to adhere to the IRS guidelines for setting a reasonable salary. Unfortunately, these guidelines are not included in the IRS Code or its Regulations. Fortunately, three recent cases now provide the guidelines necessary to maximize this legal tax savings technique. In this article, I will explore these three cases. First, I want to illustrate how to save taxes in this area,

Reducing Payroll Taxes

Consider this example to see how lowering your salary reduces payroll taxes. Let’s say you operate as a sole proprietorship and earn $100,000 of business income. This results in $14,130 in self-employment taxes. If you form an S Corporation and set your salary at $50,000, you and the corporation only pay a total of $7.650 in self-employment taxes; a substantial savings of $6,480! The remaining $50,000 of business income is paid to you as a distribution of profits, or dividend. Now to the cases to gain a further understanding of how to pay yourself a reasonable salary in the eyes of the IRS.

Watson Case

Mr. Watson was an accountant who operated as a S Corporation. His S corporation was a 25% partner in an accounting firm. In each of the years under audit, Watson paid his firm $200,000, but only took a salary of $24,000. The IRS’s valuation expert looked at the statistics for what accountant’s earn in that area of the country, and calculated a reasonable salary to be $91,044. The tax court agreed with the IRS’s assessment.

Therefore, Mr. Watson still had the majority of his income as distributions, free of the self-employment tax; but, still failed to report a reasonable salary in the eyes of the IRS.

McAlary Case-No Salary

Mr. McAlary was a real estate professional. He did well, and in 2006 took a $240,000 distribution from his corporation. He did not take any salary. The IRS’s valuation expert determined that a reasonable salary for Mr. McAlary should be $100,755. Unlike the Watson case, the court did not accept the IRS’s evaluation stating that a reasonable salary is “far from an exact science”. The tax court adjusted the IRS’s finding downward to $40 an hour, based upon other factors contributing to Mr. McAlary’s success beyond his own efforts–the favorable housing market.

Therefore, based upon the $40 hour rate, the court set McAlary’s salary at $83,200, resulting in $156,800 in distributions for the year.

The Blodgett Case

Frederick Blodgett created glass blocks for windows, skylights, and other real estate uses. In 2006, the construction industry in Southern California took a nosedive, and his business as well. In 2007 and 2008, he loaned the business $55,000. His S corporation had net business income of $877 and $8,950, respectively.

Blodgett took no salary during that time, but withdrew $30,000 each year as classified as distributions and repayment of loans. The court disagreed with the loan classification, and characterized 100% of the payments to Blodgett as distributions. The court then stated that a reasonable salary for Mr. Blodgett was $30,000, creating a net loss in his corporation for those 2 years.

Conclusion

When considering a reasonable salary, your first step id to find reliable statistics regarding the wages for you job in your area of the country. Once you have this wage comparison, then make reasonable adjustments based on the difference between your business and the average business. Here are some examples to illustrate:

• your business is less profitable than other businesses in the area
• you do not work full time
• factors other than your personal efforts led to the success of the business, such as a favorable housing market

Always document this data in your corporate minutes to prove your analysis.

Lastly, if you do not take a salary from your business, do not take any distributions.