S Corporations and Salaries

Continuing my research in comparing an S corporation to a sole proprietor, I found this article on nolo.com that discusses how to pay yourself, other officers, and shareholders.

S Corporations and Salaries: How much should I pay myself?

An S corporation (also called a Subchapter S corporation) is a small corporation that has elected to be taxed much the same as a partnership by the IRS. An S corporation is a pass-through entity—income and losses pass through the corporation to the owners’ personal tax returns. Many small business owners use S corporations. One of the biggest reasons is that an S corporation can save a business owner Social Security and Medicare taxes. However, this has become a hot button issue for the IRS.

An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes, as well as a shareholder. In effect, an active shareholder in a S corporation wears at least two hats: as a shareholder (owner) of the corporation, and as an employee of that corporation. This allows for savings on Social Security and Medicare taxes because such taxes need not be paid on distributions of earnings and profits from the corporation to its shareholders. Thus, to the extent they pay themselves shareholder distributions instead of employee salary, S corporation shareholder/employees can save big money on payroll taxes.

It’s up to the people who run an S corporation—its officers and directors—to decide how much salary to pay the corporation’s employees. When you are employed by an S corporation that you own (alone or with others), you’ll be the one making this decision. In fact, 70% of all S corporations are owned by just one person, so the owner has complete discretion to decide on his or her salary.

However, an S corporation must pay reasonable employee compensation (subject to employment taxes) to a shareholder-employee in return for the services the employee provides before a distribution (not subject to employment taxes) may be given to the shareholder-employee.

Unfortunately, many S corporation owners have gone overboard and had their corporations pay them no employee compensation at all, thus avoiding having to pay any payroll taxes. The IRS Inspector General found that in 2000 about 440,000 single shareholder S corporations paid no salary to their owners, costing the government billions in lost payroll taxes. As a result the IRS stepped up enforcement on this issue and audited thousands of S corps that paid their owners little or no salary.

If the IRS concludes that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can recharacterize the distributions as salary and require payment of employment taxes and penalties which can include payroll tax penalties of up to 100% plus negligence penalties. The IRS will do so if it concludes that the corporation paid the employee unreasonably low compensation for his or her services. For example, a CPA who incorporated his practice took a $24,000 annual salary from his S corporation and received $220,000 in dividends which were free of employment taxes. The IRS said that his salary was unreasonably low and that $175,000 of the dividends should be treated as wages subject to employment taxes. The court upheld the IRS’s power to recharacterize the dividends as wages subject to employment tax. (Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d ¶ 2010–908.)

Thus, as a general rule, it is advisable to have your S corporation pay you at least some salary–which can be on the low end of the reasonableness scale. How low can you go and still pay yourself a reasonable salary? There are no precise guidelines. IRS officials have stated that they make the determination on a case-by-case basis. Among the factors the IRS and courts consider are:

  • the duties performed by the employee
  • the volume of business handled
  • the type of work and amount of responsibility
  • the complexity of the business
  • the time and effort devoted to the business
  • the timing and manner of paying bonuses to key people
  • use of a formula to determine compensation
  • the cost of living in the locality
  • the ability and achievements of the individual employee performing the service
  • the pay compared with the gross and net income of the business, as well as with distributions to shareholders
  • the company’s policy regarding pay for all employees, and
  • the payment history for each employee.

After examining all the circumstances, they establish a range of reasonable salaries, from low to high. In one case, the IRS concluded that a reasonable salary for an Arkansas certified public accountant was $45,000 to $49,000. The accountant in that case had paid himself no salary and received $83,000 in corporate distributions. The IRS used salary information from a large financial services recruiting firm to determine what was reasonable. (Barron v. Comm’r, T.C. Summ. 2001-10.) Some IRS offices have software that provides salary information for a variety of occupations throughout the country. An S corporation (also called a Subchapter S corporation) is a small corporation that has elected to be taxed much the same as a partnership by the IRS. An S corporation is a pass-through entity—income and losses pass through the corporation to the owners’ personal tax returns. Many small business owners use S corporations. One of the biggest reasons is that an S corporation can save a business owner Social Security and Medicare taxes. However, this has become a hot button issue for the IRS.

An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes, as well as a shareholder. In effect, an active shareholder in a S corporation wears at least two hats: as a shareholder (owner) of the corporation, and as an employee of that corporation. This allows for savings on Social Security and Medicare taxes because such taxes need not be paid on distributions of earnings and profits from the corporation to its shareholders. Thus, to the extent they pay themselves shareholder distributions instead of employee salary, S corporation shareholder/employees can save big money on payroll taxes.

It’s up to the people who run an S corporation—its officers and directors—to decide how much salary to pay the corporation’s employees. When you are employed by an S corporation that you own (alone or with others), you’ll be the one making this decision. In fact, 70% of all S corporations are owned by just one person, so the owner has complete discretion to decide on his or her salary.

However, an S corporation must pay reasonable employee compensation (subject to employment taxes) to a shareholder-employee in return for the services the employee provides before a distribution (not subject to employment taxes) may be given to the shareholder-employee.

Unfortunately, many S corporation owners have gone overboard and had their corporations pay them no employee compensation at all, thus avoiding having to pay any payroll taxes. The IRS Inspector General found that in 2000 about 440,000 single shareholder S corporations paid no salary to their owners, costing the government billions in lost payroll taxes. As a result the IRS stepped up enforcement on this issue and audited thousands of S corps that paid their owners little or no salary.

If the IRS concludes that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can recharacterize the distributions as salary and require payment of employment taxes and penalties which can include payroll tax penalties of up to 100% plus negligence penalties. The IRS will do so if it concludes that the corporation paid the employee unreasonably low compensation for his or her services. For example, a CPA who incorporated his practice took a $24,000 annual salary from his S corporation and received $220,000 in dividends which were free of employment taxes. The IRS said that his salary was unreasonably low and that $175,000 of the dividends should be treated as wages subject to employment taxes. The court upheld the IRS’s power to recharacterize the dividends as wages subject to employment tax. (Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d ¶ 2010–908.)

Thus, as a general rule, it is advisable to have your S corporation pay you at least some salary–which can be on the low end of the reasonableness scale. How low can you go and still pay yourself a reasonable salary? There are no precise guidelines. IRS officials have stated that they make the determination on a case-by-case basis. Among the factors the IRS and courts consider are:

  • the duties performed by the employee
  • the volume of business handled
  • the type of work and amount of responsibility
  • the complexity of the business
  • the time and effort devoted to the business
  • the timing and manner of paying bonuses to key people
  • use of a formula to determine compensation
  • the cost of living in the locality
  • the ability and achievements of the individual employee performing the service
  • the pay compared with the gross and net income of the business, as well as with distributions to shareholders
  • the company’s policy regarding pay for all employees, and
  • the payment history for each employee.

After examining all the circumstances, they establish a range of reasonable salaries, from low to high. In one case, the IRS concluded that a reasonable salary for an Arkansas certified public accountant was $45,000 to $49,000. The accountant in that case had paid himself no salary and received $83,000 in corporate distributions. The IRS used salary information from a large financial services recruiting firm to determine what was reasonable. (Barron v. Comm’r, T.C. Summ. 2001-10.) Some IRS offices have software that provides salary information for a variety of occupations throughout the country.

http://www.nolo.com/legal-encyclopedia/s-corporations-salaries-an-irs-hot-button-issue.html

by: Stephen Fishman, J.D.

End of article

What will be interesting is what, if anything, will happen after the next presidential election. Several of the candidates are pushing for a flat tax or a use/consumption tax. Personally speaking, I agree with the flat tax, but it is something that would actually work.

Again, if you are interested in creating a corporation and incorporating your construction license, I can help. Send me an email and we’ll discuss your options.

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Starting a Construction Business

Starting a construction businessStarting a construction business isn’t easy by any means. There is a lot of planning and steps to take. I’m going to attempt to break it down to the basics.

First, what business entity to choose. If you choose a corporation or LLC you’ll want to file your articles of incorporation with the Secretary of State (SOS). This is a service I offer, but if you prefer to use an online company click here.

Next you’ll want to obtain a Federal Employer ID number. You can get this number from the IRS using their online system. It will provide you with the FEIN in just minutes.

You will need to apply for a business license in your city or county. Here is a page of helpful information regarding business licenses.

If you are going to use a fictitious business name (FBN) you’ll need to apply for it in your city or county. Generally, the same government office that issues business licenses will also handle the FBN filing.

Opening a business bank account. You’ll need a copy of the filed FBN statement with you when you open the bank account. Unless you are using your personal name as your business name, the bank will not open a business account for you unless you have the filed FBN statement.

After the SOS has issued your corporate number, you can then apply for your contractor’s license. I offer a full range of license application services. Whether you need me to complete all of your documents for you, or just a review of the documents you’ve prepared, I’ll be happy to assist you.

If you are applying for a sole owner (sole proprietor) license, you can apply for your contractor’s license at any time. If you use your personal name for the business name on your contractor’s license, you will not need to file a FBN with your city our county.

Here is something that many new corporations miss… the SOS will notify the Franchise Tax Board (FTB) when the corporate number is issued and you will need to file a tax return, even if no business was conducted or if the contractor’s license was never issued. I have heard from people who formed an S corporation, received their contractor’s license number, but never conducted any business. They did not file a return with the FTB and they failed to pay the corporate taxes when due. When they tried to renew their license they discovered that the corporation was suspended at the SOS by the FTB for overdue taxes and penalties. I highly recommend finding a reputable CPA to help you.

To break it down….

  • Choose your business entity type
  • Submit your articles of incorporation with the SOS (if you’re forming a corp)
  • Apply for an FEIN with the IRS
  • Open a business bank account
  • Apply for your contractor’s license

As I said at the top, this is a basic list of what you need to do to start a construction business. It’s obviously more involved than this, I just wanted to give you the basics to get you started.

As always, I’m available to answer any questions that you may have. Everybody’s situation is different and I’d be happy to help you navigate through this process. Feel free to email your questions to me at ContractorLicenseService at gmail.com.

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