S Corporation Distribution vs. Salary
What are your thoughts/experiences about classifying S Corporation owner income as salary vs. S corporation distributions to save Medicare taxes? Is there a rule of thumb, formula or other insight on this issue about saving taxes vs. preventing IRS scrutiny?
There is no hard and fast rule on this. It’s a total judgment call with the IRS. S corporation shareholders are supposed to be compensated with salary for a reasonable amount based upon the fair market value of their services. Typically, reasonable compensation is the amount that a business owner would have to pay for someone else to do that job. Everything else is the profits generated by that business and available to be distributed to owners.
The IRS would prefer to see a higher amount allocated to salary to maximize the FICA and Medicare taxes. S corporation owners sometimes look to allocate as much of their compensation to distributions to save on FICA taxes. However, once you have exceeded the FICA maximum, which for 2019 is $132,900, there is less in it for the IRS since the only additional tax is for Medicare which is taxed at a rate of 1.45% on all wages.
Some companies choose to go with a percentage formula for salary vs. S corporation distributions. If you take this approach in my opinion the most reasonable formulas range from 50/50 to 80/20 salary to distributions. I recommend somewhere in the range of 65/35, 75/25 salary to distributions. However, S corps located in NYC have to be mindful of the impact on NYC corporate taxes as one of the formulas for calculating NYC corporate taxes includes an add back of the officer’s compensation.
However, simply looking at it this way ignores the potential of the IRS down the road doing a simple desk audit and deciding, using their judgment, that, yes, you have manipulated your S compensation to lower your taxes, your compensation that is stated is not reasonable, and that there is a basis for restating your tax return. And looking at previously filed returns and returns that follow the year they are auditing. Which results in you amending a whole bunch of federal personal and business tax returns based upon the “reasonable” compensation number the “IRS came up with” and paying a whole bunch of business and personal taxes and penalties and interest.
Oh and another thing: if you are located in NYC as part of that you have to re-do your NYC tax returns for the years that the IRS has required you to amend which could make you subject to the above mentioned higher alternative NYC business tax.
I think it would be better to come up with a reasonable number for compensation, pay a reasonable amount of tax, and have a reasonable basis for an argument if you are audited as opposed to exposing yourself to the potential nightmare above. It’s called “insurance”.
You should remember that as you get 10 or so years close to retirement, you should up your salary to the maximum so that you get the maximum Social Security benefit when you retire.
My final comment is that you may want to consider a high end deferred compensation retirement plan as a strategy for reducing both your and the Company’s taxes. These types of plans can provide significant current tax deductions while also addressing retirement, life insurance, estate planning, and financial planning issues. And also can be used to attract and retain key employees.