Playing By the Rules in an S-Corporation
Volume 13, Number 10
Issue 610
Often, I get into heated discussions with clients who "have a friend" who paid no officers' salaries while they operate an S-Corporation that is profitable. An S-Corporation is a type of corporation that has elected to be taxed under a special section of the Internal Revenue Service Code. The corporation itself pays no tax. The profit from the corporation is placed on the owners' personal returns whether or whether not it was removed as profit. Owners are required to take salaries placed on W-2s that are subjected to Social Security and Medicare and withholding taxes, but many don't.
The friend took the profit out of the S-Corporation (it was substantial) as a "distribution" or "dividend" (and not salary through the payroll process) and thereby avoided paying social security and Medicare taxes as well as Federal and state unemployment taxes.
My client asks why I make them pay themselves a salary through the W-2 payroll process (thereby paying employment taxes) instead of just letting the S corporation be that much more profitable and then distribute the profit (without payroll taxes).
My answer is that not paying a salary to the owner or paying an artificially low one 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.
If your corporation has always been an "S" corporation, it generally cannot make a taxable "dividend" distribution on its stock. Instead, distributions to stockholders are tax free to the extent of your stock basis as long as there is profit that has been previously taxed.
The combined employer and employee social security and Medicare tax rate is 15.3% of your wages up to $90,000 for 2005). For 2005, the combined rate drops to 2.9% for wages in excess of $90,000. If you are a stockholder of an S corporation, you won't want to take no more than the "reasonable salary" from your corporation that you are required to take. You must take a salary that is reflective of the particular industry that you are employed in-pay yourself what you would pay a third-party to do your job with your expertise and experience but separate and apart from the fact that you are the owner. Treat yourself like a regular employee. This minimizes your Social Security and Medicare taxes. There is no incentive to pay huge salaries, but you must pay the compensation that is the "floor" for your industry and your position. A professional paying themselves less than they used to earn in the private sector before they started to own their own company is where trouble starts.
What's a "reasonable salary"? Determining "reasonable salaries" for S corporation stockholder-employees has always been an audit issue and in recent years 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 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 Social Security and Medicare taxation as well as employment taxes.
It's just not possible for an S-Corporation to have "profit" to distribute until it has paid its owners normal, reasonable and customary salaries.
Minimizing your Social Security and Medicare taxes by taking artificially low salaries 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."
I particularly caution people who are in their low 60s and think they can own their own corporations pay no salary or a very low, say about $11,500 or less and receive full Social Security benefits at early retirement AND have pass-through S Corporation profit. At a minimum, this is simply an overt manipulation of intending to not forfeit benefits. Strictly interpreted, this is Social Security fraud.
By holding salaries artificially low in S Corporations, you could be considered to be purposefully and willfully underpaying Social Security and Medicare taxes as well as unemployment taxes. If you are over 60, you could be accused of manipulating the calculation of Social Security benefits. You are also reducing the Social Security benefit calculations for retirement, disability and survivor benefit purposes.
Play by the rules: if you own an S-Corporation, don't ever have any profit until you've paid yourself that normal, reasonable and customary salary.
David B. Robinson, CPA
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