Every new business begins in relatively the same way. A person, or group of people, have an idea, create a business plan, obtain financing, and get a company set up. However, sometimes the decided structure for the new company is not always the best fit.
The applicability of an entity structure should always be carefully reviewed with a seasoned tax preparer or lawyer. The entity type will determine the amount of asset & liability protection available to a taxpayer along with varying ranges of tax liability exposure. All too often taxpayers fixate on tax savings without fully understanding the rules associated with a specific entity’s guiding rules. Currently, there is no “one size fits all” structure a taxpayer can take advantage of, so the allure of tax savings will, more often than not, be the ultimate driver for a decision. S-Corporations tend to be one of these entities that taxpayers proclaim as a miraculous tax savings vehicle. Are they onto something we don’t know or are there hidden dangers?? Let’s explore.
Advantages of an S-Corporation:
Asset protection- A shareholder’s personal assets will not be seized to pay the business debts or liabilities of the company unless a personal guarantee exists.
Pass-through income- Just like the widely known LLC, S-Corporations flow all Federal and State income to the respective shareholders. Note: there are a few exceptions where states do not accept S-Corporation elections such as New York. However, the benefit of passing the income to the individual level, which is usually at a lower tax bracket, is extremely helpful.
Income re-characterization- The ability to re-characterize income is the genesis of S-Corporation tax savings. Shareholders of this entity type who provide substantial services should be treated as employees and compensated through reasonable salary. If the reasonable salary requirement is met, the remaining profit can be distributed to the shareholder as ordinary income, free of self-employment tax, to the extent of their tax basis.
So, what exactly is reasonable salary, and why is it important? Let’s walk through a quick example where a “crafty” taxpayer foregoes a salary:
Assume Bill is a 100% shareholder of Bill, Inc., an S-Corporation. Bill, Inc. generated $50,000 of taxable income. Bill, in the course of running this company, decided to distribute all $50,000 to himself as a distribution instead of paying a salary which would be subject to Social Security and Medicare tax, also known as FICA, which in 2014 is taxed at a rate of 15.3%. This 15.3% rate is equally shared by the employer and employee. In this example, since Bill is both the employer and employee, he has effectively reduced his tax liability by $7,650.
Before you stop reading let’s make it clearly known that the IRS clearly prohibits this type of treatment and will punish any taxpayers found following Bill’s lead. As an owner of an S-Corporation the IRS requires a reasonable salary to be paid to a shareholder employee which incorporates all the payroll taxes found within FICA. But how exactly does a shareholder calculate a reasonable salary? The IRS has ambiguous guidance on the subject that was the result of three famous court cases which states the following nine factors should be taken into consideration:
1.Training and experience
2.Duties and responsibilities
3.Time and effort devoted to the business
5.Payments to non-shareholder employees
6.Timing and manner of paying bonuses to key people
7.What comparable businesses pay for similar services
9.The use of a formula to determine compensation
Depending on the type of business being conducted, these nine factors hold different weight in the eyes of the IRS which further complicates the issue. To date, there is no exact formula in calculating a shareholder-employee’s reasonable salary, but be warned: the IRS is looking to see a well-researched, well-documented compensation package being paid to the shareholder-employees providing substantial services to the corporation. The IRS’ scrutiny is in an attempt to curb the ill-gotten benefits of the tax-preferential distributions an S-Corporation is able to dole out to its shareholders.
It is crucial that an S-Corporation owner contact an advisor technically competent enough to navigate this highly scrutinized area to ensure compliance, or else risk steep penalties handed down by the IRS.