As a small business owner, electing to become an S-corporation can provide major tax savings compared to operating as a sole proprietorship or LLC. But with S-Corp status comes the obligation to pay yourself a “reasonable salary” subject to payroll taxes before taking distributions. Navigating the complexities around S-Corp compensation enables you to maximize the self-employment tax benefits. This comprehensive guide will explain it all - from reasonable salary determination to distribution strategies.
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Sole Props & LLCs - Paying a Steep Tax For Self-Employment
Being a sole proprietor or LLC member might make the tax landscape seem endless. You're already dealing with Federal income tax, state income tax (in most states), and potential business licensing and LLC fees. And if that wasn't enough, there's the self-employment tax on top of it.
The self-employment tax essentially mirrors the FICA tax the government collects from those with W-2 wages. It's a regressive tax, hitting the highest rate of 15.3% right from the first dollar earned, only tapering down once your income surpasses $168,600.
FICA Tax Calculations and Limitations
When dealing with Self-employment taxes or FICA withholdings via a salary, the FICA calculation remains constant. However, when you receive or pay yourself a wage, half of the FICA contribution is deemed an employer contribution, and the other half is considered an employee contribution. Self-employed individuals are responsible for the entire amount.
In 2024, get ready for some self-employment tax payments. The first $168,600 of your taxable net income goes straight to Uncle Sam - a full 15.3% taken right off the top for Social Security and Medicare.
If you're fortunate to be earning over $168,600, you get a bit of a tax break on earnings above that. The Social Security tax stops there, so for higher-earners only the 2.9% Medicare tax applies. Of course, the IRS can't let the wealthy off that easy! If you break through the $200k mark as a single filer or $250k as a married couple, get ready to fork over an extra 0.9% just for Medicare.
Saving Money Through Converting to an S-Corp Structure
Converting your business structure to an S-Corp could provide a substantial tax deduction. S-Corps shareholders who actively participate in the business are required to receive a reasonable salary, which is still subject to FICA taxes, however, the remaining profit can be distributed free of self-employment or FICA taxes.
For example, if your S-Corp has $100,000 of net income, you could set a $60,000 salary based on your role. You would only pay FICA taxes on the $60,000 wage portion. The remaining $40,000 distributed to you as a shareholder would avoid payroll taxes. By reducing the FICA taxable earnings by $40,000 the FICA tax is lowered by $6,120. This illustrates the power of S-corps to curb self-employment taxes.
Of course, the IRS scrutinizes S-Corp payroll to prevent abuse. You must be able to justify your salary level as reasonable for the services you provide.
What is a Reasonable Salary?
The IRS keeps the definition of a "reasonable salary" annoyingly vague. Determining what's reasonable isn't a straightforward, objective process. Instead, it entails considering benchmarks and past employment, with factors such as experience, duties, and market rates playing a significant role. One consideration is how much someone would pay you to perform the same task.
The 60% rule of thumb is a quick shortcut. It involves allocating 60% of your taxable net earnings for your salary and the remaining 40% for distributions. While it's commonly relied on by many accountants, it's not foolproof, and individual circumstances may not align accurately with this method. Depending on the business nature, industry standards, and owner roles, this approach might lead to salaries that are either too high or too low. So, while the rule of thumb offers simplicity, it has its shortcomings.
If the IRS inquiries about your salary decisions, it becomes essential to have a robust justification for the chosen level. Being able to clearly articulate the rationale behind your salary setting is crucial to navigating potential inquiries and ensuring compliance with IRS guidelines.
Setting Your S-Corp Salary and Distributions
To optimize self-employment tax savings, consider these guidelines when setting your S-Corp salary and distributions:
Take a reasonable salary aligned with your role and experience, based on industry data
Calculate potential FICA taxes on your net income using the 15.3% self-employment rate
Pay yourself a salary up to the Social Security wage limit to maximize FICA savings
Allocate remaining net income after full FICA taxes are met as distributions
If multiple shareholders, adjust based on involvement
Make distributions at year-end or quarterly based on cash flow
Ideally, you want to draw a modest salary to avoid IRS audit risk while distributing out the maximum amount possible. Consult a tax professional when making these determinations.
S-Corp Payroll Processing and Distribution Mechanics
Once you’ve decided on salary and distribution amounts, implement them systematically:
Set up payroll processing through an S-Corp friendly provider
Stick to consistent payroll dates (such as monthly)
Remit payroll taxes and issue W-2s annually
Approve distributions via board resolutions
Report distributions on K-1s to shareholders
Make distributions simultaneously or after wages
Regular payroll processing paired with distributions of remaining income after taxes minimizes administrative headaches while achieving FICA savings.
Real World S-Corp Compensation Examples
To illustrate potential salary and distribution decisions, consider these scenarios:
Jane, a consultant S-Corp, earns $200,000 in net income based on her billing rate and hours worked. A reasonable salary based on her specialty is determined to be $100,000. She pays 15.3% FICA taxes on the $100,000 salary and takes the remaining $100,000 as distributions avoiding self-employment tax for $11,406.
Bob and Susan, married co-owners of an accounting S-Corp, share duties equally. Their net income is $350,000. Based on equal roles and time worked, they each take a $75,000 salary, combined covering their full FICA taxes. The remaining $200,000 net income is split with $100,000 distributions to each reducing FICA taxes by $15,300.
Using a combined reasonable wage and distribution strategy tailored to your situation can lead to substantial self-employment tax deductions.
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S-Corp Payroll and Distribution Mistakes to Avoid
When establishing your S-Corp compensation structure, steer clear of these missteps:
Taking an unreasonably low salary that could prompt an audit
Paying dividends instead of wages to dodge payroll taxes
Not processing payroll or issuing W-2s
Failing to pay yourself adequately as an active shareholder
Not making distributions when cash is available
Miscalculating Social Security tax savings
Overlooking state laws on S-Corp shareholder wages
Consulting a tax advisor can help avoid costly errors when implementing your S-Corp payroll. At United Tax we would be happy to discuss your situation and see if an S-Corp election is right for your situation.
Qualifying as an S-Corp
To become an S-Corp, your business must first meet the eligibility criteria:
Be a domestic business entity (LLC, corporation, etc.)
Have 100 or fewer shareholders
Have only one class of stock
Have all shareholders as US citizens or residents
You then elect S-Corp status by filing Form 2553 with the IRS, signed by all shareholders. The S-election takes effect on the date filed or beginning of the next tax year.
Getting the most out of an S-Corp requires strategic planning around FICA rules, reasonable wages, and distributions. But the tax rewards for closely held businesses can be tremendous. Thoroughly understanding the nuances of S-Corp taxation enables maximizing the savings.
Two Important considerations Before Converting to an S-Corporation
Deciding to dive into the S-Corp realm involves more than just potential tax savings – it's a strategic dance between maintaining the necessary salary for compliance and weighing the added complexities of filing an extra tax return. Before making the leap, individuals should carefully evaluate their ability to sustain the designated salary for an S-Corp owner-employee. This entails a realistic assessment of the company's financial health, ensuring that the chosen compensation aligns with industry standards and remains justifiable in the eyes of the IRS.
Frequently Asked Questions on S-Corp Compensation
If you are considering an S-Corp conversion or are already operating as one, you likely have questions around properly structuring shareholder pay. Below are answers to some key queries:
What are the S-Corp reasonable salary reporting requirements?
S-corps must complete payroll processing and issue each shareholder-employee a Form W-2 reporting their annual compensation. Shareholders cannot avoid employment taxes simply by foregoing W-2 wages. The IRS requires W-2s to be issued even if zero salary is drawn.
Does each S-Corp shareholder have to take the same salary?
No. While often proportional based on ownership, S-Corp shareholder salaries can vary based on involvement, hours worked, experience, duties performed, and other factors. There is no requirement that shareholders earning differing amounts take identical salaries.
Can you change your S-Corp salary mid-year?
Yes, S-Corp shareholder wages can be adjusted via board resolution at any point. However, big mid-year changes without proper documentation could increase audit risk. Modifications should have a reasonable basis.
Can shareholders draw salaries higher than reasonable amounts?
There is no prohibition on S-Corp shareholders choosing to draw larger than needed salaries. However, unreasonably high wages reduce distribution tax savings. Most S-corps aim to minimize salaries within reasonable levels.
What are the self-employment tax savings from an S-Corp?
The self-employment tax savings equal the 15.3% FICA taxes avoided on distributions. For a $50,000 distribution, this would amount to $7,650 in savings compared to a sole proprietorship. Higher income translates to larger dollar savings.
How do you handle loss years with S-Corp compensation?
Net operating losses do not change reasonable salary requirements. Shareholders must still draw reasonable pay according to their roles and hours worked. Losses pass through and offset other income on shareholders’ personal tax returns.
Putting It All Together - Paying Yourself a Reasonable S-Corp Salary
The complexities of maximizing self-employment tax savings as an S-corporation require thoughtful planning around reasonable salaries, payroll processing, distributions, and compliance. But structured strategically, an S-corp can lead to substantial tax reductions for small business owners compared to operating as a sole proprietorship or LLC. If you are considering an S-corp conversion or want to ensure your existing S-corp is optimizing tax savings, the advisors at United Tax can help. We work with business owners to implement compliant, tax-advantaged compensation arrangements tailored to their situation. Reach out to schedule a consultation so we can help minimize your self-employment taxes. Our goal is keeping more of your hard-earned income in your pocket.
