Hogs Will Be Slaughtered

S-corporations, some­time when you were set­ting up your busi­ness, you chose, or some­one advised you to choose S-corporation as your busi­ness form.  One advan­tage is they avoid the “dou­ble tax­a­tion” of the C-corporation; the gov­ern­ment does not usu­ally tax S-corporations. The S-corporation passes income through to you, a shareholder, and you pay the taxes on your share.  Another advan­tage is that only part of the income passes through to you as self-employment income, reduc­ing the amount of self-employment tax you pay.  It is that sec­ond advan­tage where the audit risk lies. Get greedy and the IRS will slaugh­ter you.

Hogs will be slaugh­tered: The IRS says shareholder-employees, offi­cers, direc­tors, and other share­hold­ers who work for the com­pany, must pay them­selves wages or salary.  If you work in and on your busi­ness, and that busi­ness is an S-corporation, you are a shareholder-employee who needs to take pay.

The fastest way to an audit is to leave Com­pen­sa­tion of Offi­cers, line 7 Form 1120S, blank.  The IRS assumes no one works free.  If you are the only shareholder-employee of an S-corporation, your salary goes on line 7.  If there is more than one shareholder-employee, someone’s salary must go on line 7.

Fur­ther­more, the S-corporation must pay its “own­ers” a rea­son­able salary.  “What is a rea­son­able salary for my busi­ness?” is a legal ques­tion. Non-attorney tax pro­fes­sion­als can’t answer it, but we can dis­cuss what the IRS looks at in a tax audit.  Mov­ing along…

Div­i­dends verses Salary & Wages: The big dif­fer­ence between div­i­dend income and salary income is that the gov­ern­ment places an addi­tional 15.3% self-employment tax on wages & salaries but not on div­i­dends.  S-corporation shareholder-employees often shave their salaries to the bone in order to avoid self-employment taxes. This strat­egy can back­fire. If the IRS decides your com­pany did not pay you enough salary, they can reclas­sify div­i­dends as salary, which results in more taxes, penal­ties and inter­est.  It’s very impor­tant for you, the S-corporation shareholder-employee, to get your salary right.

So how do you fig­ure out what a rea­son­able salary is? Ask your­self what some­body else, who is work­ing in a sim­i­lar job in the same indus­try, would receive for that job:

• How many hours do you work?
• How much expe­ri­ence to you have?
• What is the aver­age local rate of pay for that job?
• How much edu­ca­tion do you have?
• What do you pay other indi­vid­u­als doing a sim­i­lar job in your company?
• Is your work pri­mar­ily in the office?  Or do you work in the busi­ness as well?
• Are there other employ­ees capa­ble of man­ag­ing the busi­ness for you?

The IRS con­sid­ers a salary rea­son­able if some­one, who was not a shareholder, would do the same job for the same pay.

You can­not decide to take no salary.  The IRS assumes no one works free.

You can­not decide to work for less than min­i­mum wage. E.g. AZ cur­rent min­i­mum wage is $7.35/hour, there­fore if you work an aver­age of 40 hours a week, 52 weeks out of the year, an annual salary below $15,288 is not enough.

You can­not decide to pay a large salary merely to increase busi­ness expenses.  If you pay a mil­lion dol­lar salary to some­one, when a $150,000 salary would be the norm, you will get in trou­ble.  In this case, you should ask, “Would an out­side investor pay this much for this par­tic­u­lar employee’s job skills?”

Other fac­tors in what is rea­son­able salary include:

• What is the size of the com­pany (small, medium, large)?
• What is the char­ac­ter of the com­pany (upscale, middle-class, humble)?
• What is the con­di­tion of the com­pany (doing well, doing OK, barely mak­ing it, los­ing money)?
• What are gen­eral eco­nomic con­di­tions like (boom­ing, cruis­ing along, lousy)?
• How com­plex is the com­pany (com­pli­cated, has a few twists, simple)?
• How do wages & salaries com­pare to Gross Income & Net Income of the business?
• What is it like to live where you do (lower or higher cost of liv­ing, uncom­fort­able cli­mate, nice scenery, many recre­ational activ­i­ties, other spe­cific local perks or downsides)?

An audi­tor may focus on just one of these fac­tors; you should con­sider all of them.

Rea­son­able salary may also be influ­enced by how much money the com­pany is making. A lower salary in a com­pany barely scrap­ing by may be OK, but not in the case of a well-run com­pany mak­ing lots of money.

Return on invest­ment (ROI): ROI is roughly how much you get out (div­i­dends, not wages & salary) given how much you put in. The IRS may also look at ROI.  If the ROI for a given type of busi­ness is 10%, then div­i­dends paid to the extent ROI is a lot higher than nor­mal may also increase audit risk.

60/40 Split: When the offi­cer is the sole employee of the com­pany, some tax pro­fes­sion­als think pay­ing more div­i­dends than wages increases the chance of an audit.  Although the Tax Court has occa­sion­ally ruled in favor a shareholder-employee tak­ing a salary far less than their div­i­dends, it is usu­ally NOT the case.  Besides, you would have to go through the entire IRS audit/appeals process to get to Tax Court to argue your case-that costs time & more money.  There­fore, many tax pro­fes­sion­als rec­om­mend a split of 60% wages/40% div­i­dends.  Note: Art & Busi­ness Con­sult­ing LLC is NOT rec­om­mend­ing the 60/40 allo­ca­tion of salary/dividends or any other spe­cific amount.

Note: When there is more than one share­holder of an S-Corporation, the S-corporation should pay div­i­dends in pro­por­tion to the amount of stock held by the share­hold­ers.  Prob­lems hap­pen when one or more share­hold­ers pay their bills directly out of the com­pany accounts. If the S-corporation clas­si­fies those pay­ments as dis­tri­b­u­tions, then the IRS may say the com­pany has dif­fer­ent “classes” of stock, which is not allowed under S-corporation rules; the com­pany will lose its S-corporation sta­tus.  S-corporations do not usu­ally pay taxes, but when a com­pany loses its S-corporation sta­tus, it becomes a C-corporation. C-corporation income is tax­able at the cor­po­rate level too, and share­hold­ers still have to pay their taxes as well.

Note: Usu­ally an S-corporation shareholder-employee works for the com­pany through­out the year, there­fore the S-corporation pays shareholder-employee through­out the year. Pay­roll taxes forms and pay­ments are due through­out the year too. S-corporation shareholder-employees should NOT decide how much the com­pany pays them at the end of the year, as the IRS assesses penal­ties and inter­est on pay­roll taxes and forms filed late.

Note: When offi­cers of an S-corporation dis­cuss wages & salaries, the sec­re­tary should record those dis­cus­sions in the min­utes of the corporation.

FYI: The state of Ari­zona requires com­pa­nies pay wages at least twice a month.

Other Advice: To avoid con­fu­sion between busi­ness and per­sonal income & expenses, as well as share­holder pay­ment clas­si­fi­ca­tion issues, do not mix (commingle) personal and busi­ness income or expenses.  Have sep­a­rate busi­ness and per­sonal bank accounts. Do not pay per­sonal expenses out of directly out of busi­ness accounts. Write checks to pay your wages and div­i­dends from the busi­ness account, deposit those funds into your per­sonal account, then pay per­sonal expenses out of a your per­sonal bank account.  Although noth­ing in the tax code specif­i­cally pro­hibits com­min­gling of funds, com­min­gled records make audi­tors drool, which is never a good sign.

When an S-corporation is los­ing money, an S-corporation may pay less.  Be sure to cre­ate min­utes, which doc­u­ment the changes in pay includ­ing an expla­na­tion of why a salary was increased or decreased.

Tak­ing a salary, when the busi­ness is los­ing money increases the S-corporation’s losses.  e.g.  In a year where the com­pany loses $10,000, if your salary is $10,000, then with the $765 employer por­tion of self-employment taxes the com­pany loses $20,765.  Whether you can deduct any part or all of that $20,765 in losses, depends on whether you have “basis” in your com­pany.  The dis­cus­sion of basis is beyond the scope of this document.

The Bot­tom Line: There is no hard and fast rule as to what a “rea­son­able” salary is.  In sum­mary you are a share­holder work­ing in or on your S-corporation, whether you are an offi­cer or not, you

• must take a salary
• that salary should be at least min­i­mum wage
• that salary prob­a­bly should be more than div­i­dends paid
• in addition, taking into account things like that your company’s char­ac­ter & con­di­tion,  the busi­ness loca­tion & gen­eral eco­nomic conditions, your salary should be sim­i­lar to what some­body else would make given sim­i­lar expe­ri­ence in the same industry.

If you need a spe­cific answer to this ques­tion, like “take X amount as salary and the Y as div­i­dends,”  you should con­sult your attor­ney for this spe­cific advice. Art and Busi­ness Con­sult­ing LLC is NOT engaged to prac­tice law.

Call us before the IRS calls you.  Small Busi­ness and tax­a­tion are our busi­ness.  If you have ques­tion about S-corporation taxes or other mat­ters, Please give Art & Busi­ness Con­sult­ing a call.  We would love to engage you as a client.

The usual dis­claimers: Although ABC has made every effort to insure the accu­racy of Taxes, Tips and Tools, mis­in­for­ma­tion, dis­in­for­ma­tion, changes, mis­takes, typos and hack­ers hap­pen, there­fore Art & Busi­ness Con­sult­ing LLC takes no respon­si­bil­ity for any action taken or results based on the infor­ma­tion sup­plied here in. The con­tent of this blog gen­er­ally applies to busi­ness and indi­vid­ual tax­a­tion in the United States of Amer­ica.  Inter­nal Rev­enue Ser­vice Cir­cu­lar 230 Dis­clo­sure:  As pro­vided for in Trea­sury reg­u­la­tions, advice (if any) relat­ing to fed­eral taxes that is con­tained in this com­mu­ni­ca­tion (includ­ing attach­ments) is not intended or writ­ten to be used, and can­not be used for the pur­pose of (1) avoid­ing penal­ties under the Inter­nal Rev­enue Code or (2) pro­mot­ing, mar­ket­ing or rec­om­mend­ing to another party any plan or arrange­ment address herein.  Art & Busi­ness Con­sult­ing LLC cur­rently does not have a cer­ti­fied pub­lic accoun­tant, human resource spe­cial­ist, cer­ti­fied finan­cial plan­ner or an attor­ney on staff; this infor­ma­tion is purely for edu­ca­tional pur­poses and not to be con­strued as legal or finan­cial advice. Art & Busi­ness Con­sult­ing LLC and its employ­ees, mem­bers and asso­ciates are not engage to prac­tice law; you always should dis­cuss legal mat­ters with your attor­ney before talk­ing to any­one else.