You are running a small business.
However, the definition we are discussing here is whether you have
elected to be taxed as a small business corporation (termed an “S”
corporation). When you file Form 2553,
"Election by a Small Business
Corporation," the IRS, upon approval, send out Letter CP261,
"Notice of Acceptance as an S
Corporation." If you read that letter carefully (don’t worry, most
don’t), you are told that your shareholders are to be paid a
reasonable compensation, if they are also employees. The problem is
what is “reasonable compensation”. Why?
In a nutshell, S Corporations,
Partnerships, and LLC’s (either operating as corporations or
partnerships) flow their profits and losses directly to the owners.
So, every penny that is profit, after (legal, documented) expenses
becomes a “dividend” to the owners. That dividend is reported on
your 1040 filing using Schedule E; the dividend is taxed as income.
[Of course, if you have a loss, that loss reduces your overall
income.] OK, you say, that makes sense, so what? Well, if you are a
partnership, ALL of that money is subject to FICA and FUTA (as well
as SUTA). [FICA includes Medicare and Social Security taxes, FUTA
are Federal Unemployment Taxes, SUTA are State Unemployment Taxes.]
This is NOT the case for S corporations (or LLC’s electing to be
corporations). Profits and Losses are not subject to FICA and FUTA.
So, if you (illegally) do not pay your shareholder-employees a
salary, then that money would (not legally) flow to the shareholders
as a dividend. NO Social Security, NO Medicare taxes, NO
unemployment taxes would be paid on what should have been legitimate
wages. That’s the problem- one the IRS corrects by making ALL of
that money subject to FICA and FUTA [IRS Revenue Ruling 74-44].
(Sorry, Charlie, you can’t call those funds loans to shareholders or
distributions other than dividends, either.) Moreover, you will be
subject to failure to deposit, failure to file, and negligence
penalties, PLUS interest. NOT where you want to be, trust me- the
penalties range from 20 to 25% of the amounts due.
The first step must be to determine which of the
shareholders are considered to be employees. Any shareholder who
provides services to the corporation shall be paid reasonable
compensation; ipso facto, that individual is an employee. Any
individual hired in the ordinary course of business is obviously an
employee- but that does not mean that person is either an officer or
shareholder of the corporation. Furthermore, in 2008, the IRS
published that corporate officers are within the definition of an
employee subject to FICA, FUTA, and other income tax withholding.
One could argue that the officer may not be- but only if no services
or very, very minor services are accorded to the corporation. Trust
me, they are few and far between. As a matter of fact, the new
instructions for 1120S [Income Tax Forms for Flow-through
Corporations] (OK, a few years old now) clearly state for line 7,
“Distributions and other payments by an S corporation to a corporate
officer must be treated as wages to the extent the amounts are
reasonable compensation for services rendered to the corporation.”
Let’s look at some numbers, which will put this problem in
perspective. To make it simple, let’s assume our corporation has a
single stockholder (very, very bad idea in practice, but we are not
discussing that issue here), with no itemized deductions. The Gross
Revenue for the firm was $ 250K, with a profit before taxes of $
100K.
|
No Salary |
Low Salary |
High Salary |
|
Salary |
$ 0 |
$ 30,000 |
$ 60,000 |
|
K-1 (S income) |
$ 100,000 |
$ 67,271 |
$ 34,976 |
Don’t forget employer payroll taxes |
1040 Adjusted Gross |
$ 100,000 |
$97,271 |
$ 94,976 |
K-1 + Salary |
Exemption/Deduction |
-8,950 |
-8,950 |
-8,950 |
|
Taxable Income |
$ 91,050 |
$ 88,321 |
$ 86,026 |
|
Federal Income Taxes |
$ 19,479 |
$ 18,681 |
$ 18,065 |
|
FICA
(employer/employee) |
$ 0 |
$ 4,590 |
$ 9,180 |
|
FUTA/SUTA
(max 6.2%) |
$ 0 |
$ 434 |
$ 434 |
Of first $ 8000 |
Total Taxes Paid |
$ 19,479 |
$ 23,705 |
$ 27,679 |
|
|
Before penalties and interest |
|
|
|
So,
now we are back to our original problem: What is reasonable
compensation? Well, there are no hard and fast rules. Things such
as training, experience, duties, responsibilities, time involvement,
payments to non-shareholder employees, and what comparable
businesses pay for similar services all come into play.
If you are doing it yourself, a simple guide is, “What would you pay
someone else to do your job?” But, that’s way too simple. If you
are starting out, you would not be able to get someone to do your
job for the money you have available. If you are in a downturn, the
employee would probably NOT take a severe reduction in salary to
accommodate the business; you, however, would (whether or not you
want to do so). So, there are other differences to accommodate.
We use a variety of computations. The first pass includes a
percentage of the gross and net revenues of the firm. We compare
these to other firms, to insure that the compensation is in bounds.
Next, we would do a salary search; a good place to start is
www.salary.com. You can plug in a
title and a zip code and be provided with a range of values. You
can search professional journals, who generally publish a salary
guide once a year.
It is also important to relate the officer’s salary to business
sales; for that you can go to
www.bizstats.com.
(This site is used by the IRS to determine the overall
reasonableness of expenses; it is NOT an official use, however.)
You can also try using the
Bureau of Labor Statistics (US Department of Labor) for their salary
data found at
www.bls.gov.
This is arranged by occupation, metropolitan region, among other
variables. (Try to keep within the 25th and 75th
percentiles.)
In the end, you are left with making reasonable assumptions to
achieve that reasonable compensation. It is not perfect- but NOT
doing it will cost you plenty. |