The S Corporation is Still a Viable Tax-Savings Option after Recent Court Rulings
The S Corporation (“S Corp”) is one of the more popular entities available to small business owners in the United States. Not only does it receive pass-through treatment for income tax purposes, it also provides an opportunity for fairly significant payroll tax savings. This aspect has always been a matter of legislative grace, and as with all situations that mix subjective interpretation and the IRS, it is important to remember: “hogs get fed and pigs get slaughtered.” Two recent cases have confirmed this admittedly unscientific approach to tax planning, and although the taxpayers lost in each of them, the cases offer the rest of us the benefit of knowing a little bit more about what not to do when structuring compensation arrangements for an owner-employee in an S Corp.
As recent articles from Forbes and the Wall Street Journal noted, both S Corp cases (one from Iowa and one from California) involved small business owners who underpaid themselves in order to minimize Social Security and Medicare taxes. Although this is not a new issue, it has become more pressing as payroll taxes have increased over the years.
Here’s how the California taxpayer got himself in trouble with the IRS: Taxpayer was a real estate broker operating his business as an S Corp; he was the sole shareholder. An expert for the IRS testified to the United States Tax Court that Taxpayer should have paid himself $100,755 in wages for 2006. Instead, Taxpayer paid himself $0 in wages and took the entirety of the S Corps’ earnings ($231,454) as dividends that were not subject to payroll taxes. As a result, the Taxpayer owed $13,700 in delinquent payroll taxes, along with $4,300 in penalties and interest.
So how does a business owner operating an S Corp avoid this unsavory situation? Simple, pay yourself a reasonable salary. And what is a “reasonable salary” you ask? Once again we are dealing with the IRS so there is no hard and fast rule to go by – the law treats each case according to its circumstances, using factors such as the nature of the employee’s work, comparable pay elsewhere and prevailing economic conditions. Compensation does not need to equal net income, but it obviously cannot be $0 either. If your business is quite profitable, take something over the FICA maximum – the savings can still be quite substantial. You will get the double benefit of avoiding an IRS audit and pitching in on your future social security benefits.
The bottom line: the S Corp is still a great business entity for tax planning purposes, just don’t try to take advantage of the system! Contact our experienced business and tax planning attorneys at The McCleskey Law Firm if you have questions or would like more information regarding this topic.