Understanding S Corporation owner's reasonable compensation part 1.

Trying to decide how to structure your business, even if you’re the only employee, is one of the biggest decisions business owners have to initially make. In this two-part blog series, I wanted to focus on some important factors regarding S Corporation status that often come up in my conversations with clients and other business owners. 

For many of my clients, they begin their businesses as a sole proprietor. This means they are the only owner and all profits go to themselves. There is absolutely nothing wrong, accounting or tax-wise, with this business model. You report your income and expenses on Schedule C of your personal Form 1040 and go about your business. However, in addition to regular income taxes, you also owe self-employment tax on your business income. 

Self-employment tax is 15.3% and is equivalent to the employer’s share of social security and medicare taxes that a business would pay if you worked for someone as a W-2 employee. As many sole proprietors soon realize, though, this self-employment tax amount can translate to a lot of money. They usually aren’t prepared for it and many end up owing money at tax time. 

You might be thinking, “what does this have to do with an S Corporation?” Well, to avoid self-employment tax, once a business is making a sufficient amount of revenue each year, they can consider electing to be taxed as an S Corporation. “Sufficient” is somewhat subjective, but it makes sense to wait until you can afford payroll services and corporate tax returns before taking this step. You can choose to become an S Corp at the start of your business or, if you are an LLC, you can elect to be taxed as an S Corp. As an S Corporation, the income from the business passes through to the shareholders’ personal income tax returns where it is taxed at their ordinary personal tax rate. If you are the only owner of the S Corp, then 100% of the business's income passes through to your personal tax return. There is also no self-employment tax on this income since the shareholder is considered an employee of the corporation. 

Another potentially attractive aspect of electing S Corporation status is Shareholder Distributions. First, some definitions: When you use your personal funds to start a business or to add money to your business checking account, those are considered Shareholder Contributions. When you take money out of your business, that is a Shareholder Distribution. Shareholder distributions, within certain limits, are not taxed. That means you can take money out of the business tax free! But the amount that will be tax free is determined by something called your “basis.” Calculating your basis is tricky and you should contact your tax preparer to help you determine what your basis in the corporation is because, trust me, you can’t figure it out on your own.

After electing S Corporation status, the Shareholder then has a decision to make. If they want to take money out of the business, how much is salary and how much is a distribution? Since distributions are pretty much tax free, business owners obviously would prefer to have 100% distributions and 0% salary. However, the IRS has said you can’t do that. In fact, starting in 2005, the IRS began cracking down on S Corp owners who paid themselves too little salary and took large distributions. So you have to figure out what a good mix of salary and distributions is. Next month, we will talk about some strategies for setting your compensation and distribution levels to keep both you and the IRS happy. 

In the meantime, if you are an S Corporation owner and need help setting your salary level, send me an email and we’ll talk.