Are you paying yourself enough?
Owners of Sub-Chapter S Corporations often pay themselves a salary and take the rest of the company profit as passive income. It’s a pretty popular tax reduction strategy. You don’t reduce your overall income tax rate, but you do save some money on the payroll taxes which amount to around 15% of your income.
But it’s really important to make sure that the salary you pay yourself in your Sub-S Corporation is relevant to what you really should be paid. Recently, the IRS won a case against an accountant, with 20 years of experience, in Iowa for only paying himself a wage of $24,000 while receiving distributions amounting to over $200,000. According the IRS, a first year accounting grad can be expected to receive a salary of around $40,000. They determined that the accountant should have paid himself a salary of $91,044. (Okay, I know you’re thinking $91,044? I can understand the $91,000 but how’d they get the $44? Don’t ask me, I haven’t a clue.)
You may be wondering, why bother paying a salary out of the S Corp and taking the rest of the profits as a distribution in the first place? Isn’t it all just profit anyway? Well yes, but there’s a difference. In the Iowa case, the man paid himself a wage of $24,000 plus he had distributions of $200,000. In essence, his company had a profit of $224,000. (I’m rounding, okay?) If he were to receive all of that income as self employment income, he’d pay regular income tax on the $224,000 (less his deductions of course) plus he’d pay 12.4% social security tax on $106,800 of that income, plus another 2.9% on the whole $224,000. That’s $19, 739 over and above his regular income tax. By paying himself a wage of $24,000, his employment taxes are $3,672. Although it doesn’t work out that cleanly, he basically saved himself about $16,000 in taxes. That is until the IRS stepped in.
For Subchapter S owners, this issue of an appropriate wage for self employment tax isn’t going to go away. Last year Congress tried to make all Sub-S income from personal service firms (lawyers, accountants, and consultants) taxable as self-employment income. The issue failed, but I suspect it will return again.
So how should you value what you pay yourself? The IRS doesn’t give us any firm guidelines. Although some accountants suggest that any personal service provider should claim 70% or more of his or her S-Corp income as wages, the IRS only revised the accountant’s self employment wage to about 40% of his income. That leaves us open for some interpretation.
One guideline I like to use for people who remain in the same career, but start a new business is what did they make performing the same service at their old company? What would you get paid if you were to be hired today at a different company for the same job? It’s a good way to substantiate that what you’re paying yourself is a legitimate wage.
To read more about the case of the accountant in Iowa, check out the Wall Street Journal link here: http://online.wsj.com/article/SB10001424052748703951704576092371207903438.html?mod=sf2tw