Salary versus Profit
Volume 11, Number 47
Issue 543
This past week I got into another heated discussion with a client who “had a friend” who paid no officers’ salary in an S-Corporation. The friend took the profit out of the S-Corporation (it was substantial) and thereby avoided paying social security and Medicare taxes on the portion of the salary that should have been shown as salary expense in arriving at profit. This is simply wrong and illegal. I can never say enough that owners of S Corporations who hold their salaries artificially low or non-existent are not complying with the S Corporation laws that require that “normal, reasonable and customary” salaries must be paid through the payroll process to owners who work in the business.
A bit of background by way of talking about C-Corporations first.
C-Corporation “Compensation (W-2 Salary) vs. Taxable Dividend Payouts. If you are a majority stockholder and an employee of your regular “C” corporation, you have probably debated whether you would pay less taxes by paying yourself “salary or bonus” (taxed at a maximum rate of 35% and generally subject to FICA tax) or a “dividend” (taxed at a maximum rate of 15% and generally exempt from FICA tax). Once you have already reached paying yourself through the payroll process a “normal, reasonable and customary” salary and you still have profit, do you give yourself a salary bonus? Although at first blush, paying a dividend may appear preferable, the total taxes paid by you and your corporation may actually be greater by paying the dividend. The dividend may actually cost you and your corporation taxes after you factor in the tax cost of the lost compensation deduction at the corporate level (compensation should be deductible by the corporation but dividends are not). The bottom line is that deciding whether to pay a dividend or compensation requires a careful analysis including detailed calculations
Corporations and Dividends. If your corporation has always been an “S” corporation, it generally cannot make a taxable “dividend” distribution on its stock. Instead, distributions to you as a stockholder are tax free to the extent of your stock basis as long as there is profit that has been previously taxed. A distribution exceeding your stock basis (you took out more than profit) will be taxed as a long-term capital gain (taxed at the maximum 15% rate) if you have owned the stock more than a year. However, if your “S” corporation was formerly a regular “C” corporation that had “earnings and profits,” it is possible that your “S” corporation distributions are “dividends” taxed at the maximum 15% rate. If your “S” corporation has “earnings and profits” and also generates too much “passive investment income” (e.g., royalties, dividends, interest, certain rents, etc.), your corporation could be subject to a 35% penalty tax and could possibly lose its “S” election.
Should My Business Operate as a “C” Corporation? There is no easy or absolute answer to this question. There are many factors to consider. For instance, although the burden of the double taxation of “C” corporation income has been diminished by lowering the tax on dividends (from 38.6% to 15%), these corporations are still subject to a double tax regime. Also, appreciated long-term capital gain assets such as goodwill sold by a “C” corporation could be subject to an overall effective tax rate of almost 45% (assuming the sales proceeds are distributed to the shareholders), compared to a tax rate of 15% if the goodwill, etc., is sold by a pass-through entity. It is true, however, that you could save some tax by trapping annually up to $50,000 of taxable income inside a “C” corporation (other than a “personal service corporation”), and later paying it out as a dividend. But ultimately, after weighing all factors, for many businesses it MIGHT be advantageous to operate as a pass-through entity (e.g., sole proprietorship, partnership, LLC, S corp) rather than as a separately taxed “C” corporation. Choosing the best type of entity for your business is a complicated task, please call David B. Robinson, CPA and your attorney before selecting or changing the form of your business.
Salaries For S Corporation Stockholder/Employees. The combined employer and employee social security and Medicare tax rate is 15.3% of your wages up to $87,000 ($87,900 for 2004). For 2003, the combined rate drops to 2.9% for wages in excess of $87,000. If you are a stockholder/employee of an S corporation, you may wish to take no more than the “reasonable salary” from your corporation that you are required to take. This minimizes your social security and Medicare taxes. Other income that passes through to you or is distributed to you as a distribution on your stock is not subject to social security and Medicare taxes.
What’s a “reasonable salary”? Determining “reasonable salaries” for S corporation stockholder/employees is a hot audit issue and this past year the IRS has taken many taxpayers to court on this issue–and won! The IRS has been particularly successful where S corporation owners pay themselves no salary even though they provided significant services to the corporation. In these cases, the courts generally held that all amounts paid out to the S corporation owner/employees were wages subject to FICA and Medicare taxation. Minimizing your social security and Medicare taxes can also reduce your social security benefits when you retire, affect disability payments and survivor’s benefits. Furthermore, if your S corporation has a qualified retirement plan, reducing your salary may reduce the amount of contributions that can be made to the plan on your behalf since contributions to the plan are based upon your “wages.”
David B. Robinson, CPA
Index of Previous Issues of Tax Fax
