What an owner of a corporation pays themselves in wages should be reasonable. Tax audit risk differs between the corporate taxes structures your corporation elects. S Corporations should have higher vs. lower tax compensation. For instance an S Corporation that pays an owner $25,000, with tax profits of $100,000 post officer salaries, has an unreasonable compensation audit risk. Why? Because compensation is subject to payroll tax, but distributions are not. Some tax advisors may suggest that an S corporation shareholder pay themselves the lowest salary possible, and distribute the major of earnings through the accumulated adjustment account (AAA). AAA is a tax term for taxed S-Corporation retained earnings that can be distributed without any additional taxes. In an audit, the IRS can reclassify AAA distributions to wages and assess appropriate payroll taxes. A costly audit adjustment, not to mention the penalties that can be involved. Here’s how.
Let’s say Ron owns 100% of 555 corporation stock, and 555 is an S-Corporation, and is the only employee. If 555 produces $150,000 of taxable earnings, net a $30,000 W-2 payment to Ron, the FICA tax combined with Ron and 555 will be $4,590. Let’s say Ron’s intrinsic value to the corporation is $85,000. This would result in $95,000 of taxable corporate earnings, net the $85,000 W-2. The additional $55,000 of taxable W-2 wages would result in $8,415 of additional FICA tax. So with a “managed” W-2, Ron can give himself a bonus of $8,000 a year. This is the IRS audit risk. Let’s say Ron follows this policy for 3 years, of paying himself only $30,000 on his W-2, and distributing the additional $55,000 as AAA distributions. If the IRS audits 555, he is subject to a $24,000+ FICA tax expense adjustment; plus penalties. What if Ron pays himself reasonable compensation of $100,000 each year on his W-2? Then he would pay $15,300 in combined employee and employer FICA taxes and he wouldn’t have any audit risk. You need an experienced tax advisor to determine what reasonable compensation should be.
So how do C-Corporations differ? They are opposite S-Corporations. In C Corporations higher wages are the audit risk. Why? Because C-Corporations tax dividends of retained earnings at dividend rates, after the earnings are taxed within the corporation. The double taxation is reduced if earnings are bonus payments from the corporation to shareholder(s).
Let’s say a corporation earns $250,000, net shareholder Ron’s salary of $45,000. If Ron distributes $100,000 from the corporation he would first pay $39,000 in federal income taxes, and then be taxed on the dividend at 15%, so another $15,000 of federal tax. The total federal tax, not to mention state taxes, to distribute the $100,000 would be $54,000+.
The additional $100,000 distribution would be say less than $30,000 of tax in an S-Corporation. If Ron paid a bonus payment of $250,000 on his W-2, his total federal tax on the $295,000 of W-2 earnings would be maybe $75,000. The tax on a dividend payment of $250,000 from a C-Corporation would exceed $125,000, and not include the $5,000+ of personal tax on Ron’s 1040, if married filing jointly.
It’s easy to see the tax savings from careful tax planning. For instance, Ron could elect S status for his corporation, and reduce his tax liability – significantly. Either way, you can see the advantage of an experienced tax advisor to determine reasonable compensation for employment wages for shareholders in a corporation.
Summary:
If you are a corporate shareholder, talk with tax advisor to conference on ways you can reduce audit risk and minimize tax on your corporate earnings.