It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.
A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.
Calculating the Right Number
Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.
The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).
Salary Case Examples
First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes. However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined. That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.
To see how all this is viewed by the IRS, let’s examine the results of precedent cases:
- The S Corporation Accountant—David Watson operated his accounting business as an S corporation. His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.
In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.
However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.
In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.
- The Real Estate Professional—Sean McAlary entered the real estate business before the housing crash. His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.
Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.
- The Glass Blocks Manufacturer—Frederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall. So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.
For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.
It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.
Applying the Lessons
You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.
Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:
- Your business’s profit relative to similar businesses in your area (if your profits are smaller);
- The number of hours you work (if you work less than full-time); and
- Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).
If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.
As a final note, you do not have to take a salary if your S corporation is not making a profit. Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.
Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.
- Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details. ↑
- $50,000 x 15.3 percent. ↑
- Rev. Rul. 59-221. ↑
- Watson v US, 668 F.3d 1008 (8th Cir.). ↑
- Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62. ↑
- Glass Blocks Unlimited, TC Memo 2013-180. ↑
- See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618. ↑