Timely tax-saving tips and strategies

Tax tip #6

 

Reducing your payroll tax liability, while paying yourself “reasonable” compensation as an S Corporation stockholder

In the last issue of this newsletter, I discussed a way to reduce your payroll taxes if you’re an S Corporation shareholder, by deducting personal items tax-deductible items on your S Corp return. In this article I discuss another way you can reduce your S Corp payroll tax liability.

I mentioned that you’re required to pay yourself a reasonable salary if you withdraw funds from your S corporation, and you’re an officer of the corporation. An officer is defined as an employee, according to IRC section 3121(d).

On the IRS website at http://www.irs.gov/newsroom/article/0,,id=200293,00.html, “Wage Compensation for S Corporation Officers”, the reasonable compensation requirement is described in some detail. The salary level must be “reasonable and appropriate”. The article lists some factors used by the courts in determining reasonable compensation, such as training, experience, responsibilities and payments to non-shareholder employees. The determination is made on a case-by-case basis.

Unlike the net income of sole proprietorships and partnerships, which is subject to the self-employment tax, S Corporation net income is exempt from it. The SE tax rate is 15.3%, which can be substantial for a small business owner. The objective of the IRS requirement is to increase the collection of payroll taxes, that can’t be collected based on S Corp net income, by requiring the payment of a salary subject to payroll taxes. That makes it more difficult for S Corporation shareholders to simply distribute corporate funds to themselves tax-free, considered a return of capital, as a means of withdrawing money from the corporation. 

A good way to determine what level of salary is “reasonable and appropriate”, is to determine what the value of the officer’s, i.e. your services are to the corporation, and then compensate yourself based upon that value. If your contributions to the corporation’s success are important enough, you should expect to be paid a significant share of its revenue or profits. How much of a share can be determined by (a) reference to financial ratios published in Risk Management Association (RMA) and industry publications, and (b) comparing the salary level with that paid by similarly sized companies within the same geographic region.

So how do you minimize the amount of payroll taxes you pay to the Government? You could provide fewer services to your corporation. By not serving as an officer, for example, you probably wouldn’t have as much responsibility for its success. You can hire someone to serve as an officer, such as a spouse or other relative. That person would be accountable to you. The corporation would then be run like a larger corporation with a more formal structure. Your role could be limited to providing freelance services as an independent contractor. Your compensation would then be based on the market value of your services, which would be less than if you were functioning as an officer with broader responsibilities.

If the combined value of your services and the officer’s services are less than what the value of your salary as an officer would be, you can justify paying less in compensation and therefore less in payroll taxes. As long as these transactions are conducted at arm’s length, you should have no difficulty having the deductions accepted by the IRS.