How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.
How To Start And Run Your Own Corporation
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S Corporations and Reasonable Salary
(Long Version)



New Treasury Study Proposes Changes To S Corporation Taxation

A 2005 Treasury Department study, Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations, suggests major changes in how S corporations are taxed. The study suggests shareholders owning more than 50% of the S-corporation stock and who are active in operating the S corporation should pay employment taxes on their entire portion of the S-corporation's earnings. If adopted as legislation, this would be a major blow to small businesses which operate as S corporations. (As discussed below, I believe such a tax change is unlikely.)

S Corporations and Reasonable Salary

A topic discussed at length in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners is the advantage S corporations have over sole proprietorships and limited liability companies (LLCs) when it comes to FICA or employment taxes.

S corporations can legally pay what is considered a "reasonable" salary to shareholders who are officers of the corporation and who work for the corporation. An officer of an S corporation is treated just like any other employee. The officer's salary is subject to employment taxation. Employment taxes chop off about 15% of a salary, with the amount going to the employee's Social Security and Medicare.

Amounts retained within the company aren't subject to employment taxes. These retained earnings are a key to corporate growth. Once a reasonable salary has been paid to shareholder-officers who are active in operating the corporation, amounts in excess of a reasonable salary can be distributed as "dividends" (also called distributions). These distributions aren't subject to employment taxes.

S corporations allow entrepreneurs to legally save thousands of dollars per year in employment taxes. A profitable S corporation might save the owner-officer $6,000 per year over operating as a sole proprietorship or as a limited liability company. (Limited liability companies are usually taxed as sole proprietorships if there is one owner. Technically, while S corporation officers pay employment taxes, sole proprietors pay self-employment taxes. Employment taxes and self-employment taxes are essentially the same thing. Both fund Social Security and Medicare.)

Some S-corporation owners abuse the privilege of operating an S corporation. For example, some have companies earnings hundreds of thousands of dollars per year, pay zero salary to officer-shareholders who clearly are active in operating the business, and pay employment-tax-free distributions to the officer-shareholder. This clearly is an abuse.

Reasonable Salary and S Corporation Losses

Recall, a reasonable salary is considered fair compensation for the work performed.

Amazingly, some tax advisors suggest officers active in operating an S corporation that is experiencing net operating losses should still pay themselves a "reasonable" wage. This line of thought has never made sense to me. I believe most new S corporations losing money pay no officer salary. Other tax advisors suggest that as long as the S corporation isn't paying money out to shareholders as employment-tax-free distributions, salaries do not need to be paid. This seems to agree with what the IRS says.

The IRS writes:

The IRS sends this reminder: An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before a non-wage distributions may be made to that shareholder-employee [emphasis mine]. This issue has been identified as an area of non-compliance and will receive greater scrutiny in the foreseeable future.

 

Suppose a "reasonable" salary is $30,000 per year for part-time operation of an S corporation. Then, employment taxes take approximately $4,500 per year. Suppose this S corporation is owned by a single-owner who has saved $20,000 to start his own business. Also assume the company loses $15,000 in its first year of operation.

Does it make sense the single-owner should pay himself $30,000 in salary, report a corporate loss of $45,000, and pay $4,500 in employment taxes for the privilege of losing $15,000? Even if the $30,000 in salary isn't removed from the company, but deferred, in this case, a $15,000 loss of working capital turns into a loss of $19,500, leaving the new entrepreneur cash-strapped. In this scenario, paying a "reasonable" salary would be unreasonable. It would destroy the entrepreneur's dream of running a business.

A sole proprietorship doesn't have to pay employment taxes on "phantom" wages. Paying employment taxes of $4,500 for the privilege of losing $15,000 is ludicrous. I give this example to show how some tax advisors take the requirements of a "reasonable" salary to unreasonable extremes. The IRS shouldn't (and usually doesn't, to the best of my knowledge) give S-corporations losing money any problems if no salaries are received by major shareholder-officers (assuming, of course, no other employment-free distributions are made).

One case where an officer of an S corporation might reasonably receive a wage while the company loses money is when the company has received funding from investors and a salary for the officer is agreed upon by the investors and the entrepreneur. Suppose the S corporation owner is starting a clothing store, isn't financially independent, and must devote full time to the shop. This entrepreneur needs income to live. Investors in this case will probably agree that a fair salary is necessary, so the entrepreneur can devote full time to the business.

Earning $500,000 Per Year And Taking No Salary. Reasonable?

While an S corporation losing money can avoid paying a "reasonable" salary, what about a company that is retaining most or all of it's earnings? If the company has modest earnings, it seems reasonable for the company to retain cash for future growth.

What about an extreme case? Consider a computer-consultant-software-engineer who earns $500,000 per year and who chooses to pay himself zero salary. Suppose the entrepreneur keeps all the money within the S corporation. (Because the $500,000 flows through to the entrepreneur's personal 1040 income tax return, this entrepreneur would need another significant source of income to cover the income taxes. This might be the case if the entrepreneur had substantial stock holdings from previous employment. Phantom income is discussed in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.)

This scenario seems a bit dicey. It could be argued the entrepreneur should receive a reasonable wage for his work as a computer programmer. For example, $50,000 per year might be considered a reasonable salary. It's possible a big chunk of the $500,000 comes from software sales not directly tied to currently performed "work."

That the entrepreneur isn't paying any money from a very profitable S corporation is the issue. If the entrepreneur tried to pay employment-tax-free dividends without first paying a reasonable wage, then the entrepreneur would clearly be running afoul of the spirit of the law. But, the situation seems a bit vague when earnings are piling up within the company. The safest procedure is that once an S corporation can pay a reasonable salary to officer-shareholders, it should do so. (Unlike with a C corporation, there aren't penalties for retaining too much money within a small S corporation. One issue is that as this money is invested, it's important to know how much income comes from operations relative to how much comes from passive investment.)

Removing Excess Earnings As Dividends

The key advantage to paying a reasonable wage in our software entrepreneur's case is that once a reasonable wage is paid, amounts in excess of that can be distributed without paying employment taxes. These distributions must flow to shareholders in proportion to their stock holdings. In this case, the software engineer owns 100% of the S corporation.

With a salary of $50,000, we see the software designer saves approximately $6,000 per year in employment taxes compared to operating as an LLC or as a sole proprietor. (We just did a quick back-of-the-envelope calculation, using the maximum wage base for Social Security of about $90,000. Salaries above the wage base aren't subject to Social Security. All amounts are subject to Medicare. But, we neglected that 3% Medicare portion which would be paid on all amounts. The result is that about 15% is paid on an extra $40,000.

Incidentally, for those earning tens of millions of dollars, even a couple percent in extra Medicare taxation adds up. See: Corporations Help Small Business Owners Save On Taxes: Vice presidential candidate John Edwards saved $600,000 with his S Corporation. Also, see: How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.)

Funding Social Security and Medicare

The proposed S corporation tax changes are targeted toward those S corporation officer-shareholders who pay zero salary but who have higher earnings (S-corporation officer-shareholders like our software engineer). However, the study doesn't seem to adequately address the issue of the struggling clothing entrepreneur or the case where a small S corporation might be losing money. The Treasury study claims the goal is to make the taxation of small businesses operating as sole proprietors and S-corporations equivalent.

Quoting the study:

"In summary, inequities exist between the employment tax liabilities of sole proprietors and the employment tax liabilities of the owners of single-owner S corporations. The employment tax methodology applied to S corporations does not properly address the facts and circumstances related to the predominant ownership structure of today’s S corporations. This condition is largely the result of Revenue Ruling 59-221 issued by the IRS in 1959 because the 1958 statute that established S corporations in tax law was silent on the employment tax treatment of the corporate profits.

***

Given equal amounts of income subject to employment taxes, owners of single-shareholder S corporations and sole proprietors are similarly situated for employment tax purposes. However, a fundamental and significant inequity is created between sole proprietors and owners of single-shareholder S corporations by the manner in which taxable income is determined, since sole proprietors pay employment taxes as a percent of all profits, while owners of single-shareholder S corporations pay employment taxes on only the portion of profits they unilaterally select as their salaries.

***

The 1959 Revenue Ruling that created this inequity has had three major detrimental effects on the tax system. First, the S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses. In 1959, the maximum potential loss of employment tax revenue from allowing owners of single-shareholder S corporations to select their own salaries would have been only $8.3 million ($49.1 million in Calendar Year 2000 dollars). In TY 2000, the cost was $5.7 billion due to historical increases in employment tax rates and the ability of nearly 80 percent of S corporation owners to minimize their employment taxes by minimizing their salaries.

***

Second, Revenue Ruling 59-221, in effect, places the burden on the IRS to prove that the salary chosen by the owner of a single-shareholder S corporation is not "reasonable" (i.e., commensurate with the services the shareholder provided to the S corporation). Dealing with this issue on a case-by-case basis puts a severe strain on the limited resources of the IRS. In TY 2000 alone, 36,000 single-shareholder S corporations with profits of $100,000 or more passed through total profits of $13.2 billion to their sole owners without paying any employment taxes. The cost of the IRS resources needed to effectively combat such a large problem on a case-by-case basis would be prohibitive.

***

To eliminate the employment tax shelter for most S corporations, increase Social Security and Medicare employment tax revenues by $30.8 billion and $30.2 billion respectively between Calendar Years 2006 and 2010, provide for equitable employment tax treatment of taxpayers, and reduce the burden on IRS examination resources, we recommended the IRS Commissioner inform the Assistant Secretary of the Treasury for Tax Policy of the detrimental effects discussed in this report of Revenue Ruling 59-221 that was apparently issued under the historically inaccurate assumption that most S corporations would involve multiple shareholders. The IRS Commissioner should consult with Treasury regarding whether the detrimental effects of Revenue Ruling 59-221 should be reversed through the issuance of new regulations or through the drafting of new legislation, either of which should subject all ordinary operating gains of an S corporation that accrue to a shareholder (including the shareholder’s spouse and dependent children) holding more than 50 percent of the stock in the S corporation to employment taxes

***

The Commissioner, Small Business/Self-Employed (SB/SE) Division, disagreed with the report recommendations

Sole proprietorships and S corporations were, respectively, the first and second most prevalent types of business organizations in TY 2000. For TY 2000, there were approximately 17.9 million sole proprietorships that reported approximately $245 billion in profits from business operations. Also for TY 2000, approximately 2.9 million S corporations reported approximately $200 billion in profits from business operations.

So, what are we to make of these proposed changes? Remember, this is only a study and it seems questionable whether such a change in the tax of S corporations could come about politically. In addition, the commissioner of the Small Business Division disagreed with the recommendations of the study.

Many small business owners would oppose such a change. Today, we've just had repeated massive rounds of tax cuts, tax cuts which needed to sunset in the future because, without the sunset provisions, when Americans saw the true cost of the tax cuts, they'd object to the bankruptcy of our country. The key tax issues that need to be addressed, like the Alternative Minimum Tax (AMT), are dealt with on a year-by-year basis. We have a massive deficit. And, the future funding of Social Security and, primarily, Medicare threatens to consume a huge portion of future tax revenue collected.

Clearly, the Treasury is looking for ways to boost its tax collections. It appears it will try targeting small business owners. By depriving small one-person S corporations of the ability to shield earnings not paid as wages from employment taxes, small businesses would have less working capital and less money to reinvest in their business.

Taxing Sole Proprietorships and S Corporations The Same

It's true current tax law significantly favors a one-person business operating as an S corporation. This is why many financially savvy entrepreneurs operate S corporations. The solution isn't to take away the ability of S corporation officer-shareholders to control the amount of money they withdraw from their companies as salaries. Instead, this same freedom of choice should be given to one-person sole proprietorships and limited liability companies. If a sole proprietor earning a modest $40,000 per year would like to save the extra $6,000 that is paid in self-employment taxes to reinvest in her business, she should be allowed to make that decision. That extra amount might, in future years, be the difference between ultimate success or failure in operating a business.

Peter Hupalo,
Author of
How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners