Don’t Let the IRS Set Your S Corp Salary

Avoid Trouble: Don’t Let the IRS Set Your S Corporation Salary

You likely formed an S corporation to save on self-employment taxes. If so, is your S corporation salary:

• nonexistent? 
• too low? 
• too high? 
• just right? 
  

Getting the S corporation salary right is important. 

First, if it’s too low and you get caught by the IRS, you will pay not only income taxes and self-employment taxes on the too-low amount, but also both payroll and income tax penalties that can cost plenty.

Second, in most cases, the IRS is going to expand the audit to cover three years and then add the income and penalties for those three years.               

Third, after being found out, you likely are now stuck with this higher salary, defeating your original purposes of saving on self-employment taxes.            

Fourth, your tax advisor can get slapped with preparer penalties.

Saving on Self-Employment Taxes

For 2020, self-employment taxes are assessed as follows:           

1. The first $137,700 of self-employment income is taxed at 15.3 percent.1 To get to self-employment income, you multiply net income by 92.35 percent.  Planning note. This means that your potential savings at the maximum self-employment tax rate occurs on up to $149,107 of your 2020 net income ($137,700 ÷ 92.35 percent).       

2. For amounts of self-employment income between $137,700 and $200,000, you get hit with the 2.9 percent Medicare tax.
                              
3. For amounts of self-employment income in excess of $200,000 ($250,000 on a joint return), you get hit with a 3.8 percent tax (2.9 percent for Medicare and 0.9 for Obamacare).                   

Self-employed. Your biggest savings occur when you can encroach on the 15.3 percent. You trigger these savings at the rate of 14.13 percent for every dollar below $149,107.  This is how you should think as a self-employed person who is considering becoming an S corporation.               

S corporation. But once you are an S corporation, you save on payroll taxes with salary below $137,700, which are assessed at 7.65 percent on the employee (you) and 7.65 percent on your corporation, for a total savings of 15.3 percent.                   

Example. Sam takes a cash salary of $37,700 and an S corporation distribution of $100,000. His payroll tax savings are $15,300.               

Don’t judge Sam’s cash salary as too low yet. It might be okay, as you will see later in this article.

Do This

Put yourself in the IRS examiner’s chair. You ask an S corporation owner-employee, for example, “What’s your basis for the $63,231 salary?”

What would you (remember, you are the IRS examiner) like to hear and see so you can accept the salary as reasonable?               

We don’t know for sure because, as the IRS says in its Fact Sheet “Wage Compensation for S Corporation Officers:”                   

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.       

But you have to believe that having the dollar amount of the reasonable compensation in a written document that’s included in the corporate minutes creates a great first and perhaps lasting impression. The minutes take on additional meaning if they contain a reasonable compensation document that’s updated annually.       

Getting to the Number

The IRS did you a big favor when it released its “Reasonable Compensation Job Aid for IRS Valuation Professionals.”

The IRS states that the job aid is not an official IRS position and that it does not represent official authority. That said, the document is a huge help because it gives you some clearly defined valuation rules of the road to follow and takes away some of the gray areas.           

Three approaches. The job aid lists three general approaches to reasonable compensation:               

1. Market approach
                              
2. Income approach
                              
3. Cost approach
                                                  

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Market Approach               

The market approach to reasonable compensation compares the S corporation’s business with others and then looks at the compensation being paid by those businesses to employees who look like you, the shareholder- employee who is likely the CEO.               

The question to be answered is, how much compensation would be paid for this same position, held by a non- owner in an arm’s-length employment relationship, at a similar company?

In its job aid, the IRS states that the courts favor the market approach, but because of challenges in matching employees at comparable companies, the IRS developed other approaches.

Income Approach

The IRS says the income approach, which is based on the independent investor test, can be correctly applied only when the fair market value of the company is available for each year that compensation is being examined. As a result, the market approach is generally more useful than the income approach in a reasonable compensation analysis.                       

S and C corporations. The reasonable compensation issue applies to both the S and C corporations, albeit there will likely be fewer C corporation issues now that the C corporations have a top tax rate of 21 percent. But the following applies, in general:       

• The owner of an S-corp wants a low salary
• The owner of a C-corp wants a high salary

The IRS job aid deals with both the too-low and the too-high salary issues.

Cost Approach

The cost approach breaks your employee activities into their components, such as management, accounting, finance, marketing, advertising, engineering, purchasing, janitorial, bookkeeping, clerking, etc.

The IRS, in Appendix H to its job aid, lists five court cases wherein the courts agreed with the IRS’s cost approach in finding the compensation to the C corporation shareholder-employees too high, but disagreeing on the dollar amount of the reasonable compensation.

With the S corporation, you are generally looking for the low salary to save on payroll taxes. The cost approach can provide excellent proof for the various jobs that you perform as a shareholder-employee of your S corporation.               

We found a resource at https://rcreports.com/ that could prove valuable in establishing a reasonable salary for the shareholder-employee. We have no relationship with this resource, but we are familiar with some tax professionals who use it to assist their clients. We are also familiar with the databases it uses to generate the compensation levels.               

Here's an example of how the cost approach works to support a $71,019 salary as reasonable compensation for this S corporation owner whose corporation had $3.5 million in revenue and 19 employees:

 Health Insurance               

The S corporation’s payment or reimbursement of health insurance for the shareholder-employee and his or her family goes on the shareholder’s W-2 and counts as compensation, but it’s not subject to payroll taxes so it fits nicely into the payroll tax savings strategy for the S corporation owner. 

Pension

The S corporation’s employer contributions on behalf of the owner-employee to a defined benefit plan, simplified employee pension (SEP) plan, or 401(k) count as compensation but don’t trigger payroll taxes. Such contributions further enable the savings on payroll taxes while adding to the dollar amount that’s considered reasonable compensation.                   

Planning note. Your S corporation compensation determines the amount that your S corporation can contribute to your SEP or 401(k) retirement plan. The defined benefit plan likely allows the corporation to make a larger contribution on your behalf.           

Section 199A Deduction                   

The S corporation’s net income that is passed through to you, the shareholder, can qualify for the 20 percent Section 199A tax deduction on your Form 1040.           

Takeaways                   

If you want your S corporation salary to hold up in an IRS audit, do two things:               

1. Make sure the corporate minutes name your salary.
                              
2. Have documents that prove your salary is reasonable.
    

The question is, who will set your salary—you or the IRS? With documentation, you put yourself in the driver’s seat.                   

Both you and the IRS have two viable approaches (from the three in the job aid) to finding the reasonable salary for the S corporation owner-employee:                   

1. Market approach
                              
2. Cost approach
                                          

Regardless of the approach used, if you have (1) the salary in the S corporation minutes and (2) documentation that proves your salary is reasonable, you can sleep well at night.

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