Fresh Look at Reasonable Compensation for S-Corp Shareholders
As an S-Corp shareholder, how do you know if you’re taking the most advantageous wage? Let’s take a closer look at reasonable compensation and how to settle on a wage that will save you money come tax time.
First, let’s lay down the ground rules. If you own 2 percent or more of a corporation and are active in that corporation (meaning that you're working for that corporation and not just an investor), you are an employee. And as an employee, you—the shareholder—must be paid a reasonable wage for services you perform. This wage needs to be reasonable under the facts and circumstances of your employment.
Why is this important? There's a strategy to be used for S-Corp shareholders. "Reasonable compensation" is not a defined point; it's a range. You want to be on the low end of that range for two reasons. Both have to do with taxes.
S-Corp Reasonable Compensation and Social Security and Medicare Tax
Wages are subject to Social Security and Medicare tax withholding. Your employer must match your Social Security and Medicare contribution. When you're an employee shareholder, you pay 7.65 percent Social Security and Medicare tax, and your corporation matches that amount.
So, the real Social Security and Medicare tax burden is 15.3 percent. Simple math says the lower the wage, the less tax you'll pay as an employee and your corporation as an employer. Thus, taking a lower reasonable wage will result in payroll tax savings.
S-Corp Reasonable Compensation and Income Taxes
President Trump signed the Tax Cut and Jobs Act into law late last year. In that tax bill was a special deduction called the Section 199a deduction. It has a great benefit for pass-through business entities, which is what an S-Corp is. The new Section 199a deduction gives S-Corp shareholders a deduction on their individual return up to 20 percent of the pass-through profits.
For example, if an S-Corp shareholder receives a K-1 form saying they must report $100,000 of S-Corp profits on their individual return, under Section 199a, that shareholder may only pay tax on $80,000 (after the 20 percent deduction). There are rules that apply to Section 199a, but for now, we'll keep it simple. Simple math says the lower your wage, the higher you’re S-Corp profits and that means a bigger Section 199a deduction and the end results is Income tax savings.
The bottom line is this: If you take a reasonable wage that's on the lower end of the scale, you're saving on Social Security and Medicare taxes and paying less income tax due to Section 199a.
What Is Reasonable Compensation for an S-Corp Shareholder?
This brings us to the question: What is reasonable? What you consider reasonable may not be the same as what the IRS considers reasonable. Kaiser Tax looked at recent court cases regarding reasonable compensation audits and found that the IRS's numbers are based on statistical surveys of different industries, employers, labor, and government entities. The IRS uses these numbers to come up with what they think is a reasonable salary for somebody in every occupation.
Determining your reasonable wage is a matter of doing your research and finding reliable stats for your situation. From those statistics, you can make downward adjustments. For example, federal employees are historically paid low wages because they gain an incredible amount of benefits: pension, health insurance, etc. Because of these benefits, the government can pay employees less money.
You can use a similar strategy by having your S-Corporation pay for your health insurance premiums and make large contributions to your retirement plan. So, when we say reasonable wage, what we're really looking at is reasonable compensation.
When to Pay a Reasonable Wage to an S-Corp Shareholder
A question we get frequently is what if a company is showing a small profit or even a loss—does it still need to pay a reasonable wage to the employee shareholder? The answer is simply, no, you don't have to pay a reasonable wage when a company is at a break-even, making a small profit, or showing a loss.
However, if you're not taking salary, you should not be taking distributions or making any loan payments back to yourself. The IRS wants to see wages being paid before optional distributions or loan payments.
Exceptions to the S-Corp Reasonable Wage Rule
With every rule, there are exceptions. Reasonable compensation with S-Corp shareholders is just another example. Typically, you want to take a lower reasonable wage to save on Social Security and Medicare taxes and Income taxes with the new Section 199a deduction. However, there are two clear reasons someone may want to deviate from this strategy.
Shareholders who are getting close to retirement age may want to rethink this strategy. One of the drawbacks of the plan above is that it could affect your Social Security benefits once you retire. Often, as shareholders get closer to retirement, they'll increase their salaries and pay more in Social Security taxes, so they can reap a greater Social Security benefit. Your Social Security benefit is based on your 35 highest-paid working years. What some S-Corp shareholders will do later in their working life is increase one or more of those 35 years by paying more salary.
You'll also see corporations add spouses to the payroll. When you add a spouse to the payroll, you're adding additional Social Security and Medicare taxes, so why would you do that? One of the reasons is so that spouse can collect Social Security benefits later in life. An individual must have 40 working quarters (equivalent to 10 years) to be eligible to receive Social Security benefits. Many times, one spouse will be the primary income producer for the household, and another spouse is the stay-at-home provider. However, we typically find the stay-at-home spouse is almost always involved in the company. That spouse could be paid a wage. By doing so, you're adding to their number of quarters worked and this will help the spouse qualify for their Social Security benefits.
The second reason why you may want to take a higher salary is for retirement planning purposes. Some taxpayers are simply not going to qualify for a Section 199a deduction. Like any other tax rule, it's complicated. While many S-Corp shareholders will enjoy the deduction, not everyone is going to. These individuals may be better off taking a higher W-2 wage to allow for a greater retirement contribution by the company.
For example, if you're using a SEP, 401(k), or profit-sharing plan at your company, the amount an employer (your corporation) can contribute to a retirement plan is a function of your W-2 wages. The higher the W-2 wage, the higher the retirement contribution.
The Bottom Line on S-Corp Reasonable Compensation
Under the Section 199a deduction, the lower your wages, the higher your profits, the greater your Section 199a deduction. An S-Corp shareholder gets that special Section 199a deduction on the company profits, but not on the wages. That’s why we want to keep the wages on the low side—to maximize the Section 199a deduction.
The IRS does audit corporations for reasonable compensation to their S-Corp shareholders. We've learned over the years that the IRS goes after the blatant abusers—people who are taking $100,000 out of their company and paying themselves $5,000 in wages and $95,000 in profit distributions. If you make efforts to be in the reasonable range, the IRS simply does not have the resources to go after you.
In summary, most S-Corp shareholders will use the strategy of using lower reasonable compensation to save on employment taxes and now income taxes through Section 199a deduction. That shareholder needs to be careful to not be too low or risk an IRS audit. We suggest you look at the same statistics the IRS would use to determine what is reasonable for your situation. Then, determine how you can take that number down by other factors (ex: non-taxable benefits). For help determining your reasonable compensation, contact Kaiser Tax today.