One of the main benefits of an S corporation is the potential to reduce payroll taxes on distributions to shareholders. Payroll taxes significantly impact self-employed professionals, as they owe an additional 15.3% on top of regular income taxes. This advantage is particularly useful when an individual serves as both an employee and an owner of the S corporation. To minimize their taxes, the individual can choose to receive a smaller salary and take a larger portion of the entity’s income as distributions, which are not subject to payroll tax. Here's an example to illustrate this concept:
Example:
Daria Nagal is the sole shareholder of Daria Nagal CPA, an S corporation. She receives a salary of $80,000 from the corporation, paying $6,120 in payroll taxes (a tax rate of 7.65%). The corporation matches this amount, resulting in total payroll taxes of $12,240. If Daria reduces her salary to $60,000 and takes an additional $20,000 as a distribution, maintaining her total income of $80,000, she and the corporation will save $3,060 in payroll taxes (calculated as $20,000 × 15.3%). This saving arises because S corporation distributions are treated as non wage distributions which are not subject t payroll tax.
To prevent shareholders from avoiding payroll taxes entirely, the IRS requires that shareholders who are active in the business receive a reasonable salary. This requirement also applies if a family member provides services to the S corporation; reasonable compensation must be given before any remaining income is allocated to other family members' stock.
Establishing Reasonable Compensation
Determining reasonable compensation involves assessing the shareholder-employee's contributions to the S corporation based on the nature of the corporation’s gross receipts. The IRS primarily looks at these areas:
Services provided by the shareholder Services provided by non-shareholder employees Contributions from capital and equipment
Payments to the shareholder should be treated as distributions if the gross receipts are generated by non-shareholder employees, capital, and equipment. On the other hand, if the gross receipts are generated by the shareholder’s personal services, these payments should be classified as wages subject to payroll taxes.
Additionally, the shareholder-employee should be compensated for administrative work that supports other income-generating employees or assets. For example, a supervisor may not directly generate gross receipts but assists those who do.
Factors for Determining Reasonable Compensation:
Compensation agreements Dividend history Duties and responsibilities Payments to non-shareholder employees Use of a formula to determine compensation Time and effort devoted to the business Timing and manner of paying bonuses to key personnel Training and experience Compensation for similar services in comparable businesses
The main rule is that the corporation should pay reasonable compensation to the S corporation shareholder before making distributions to the shareholder. This means there are generally four compensation options for the S corporation owner:
- Reasonable compensation plus distributions,
- Reasonable compensation with no distributions,
- Wages less than reasonable compensation with no distributions, or
- Pay neither wages nor distributions
While minimizing compensation can reduce payroll taxes, it also limits the amount that can be contributed to qualified retirement plans, such as a SEP IRA. The SEP IRA contribution is based on the shareholder-employee's W-2 and not on the S corporation's net profit. Therefore, it is often beneficial to set a compensation level that maximizes contributions to retirement plans without exceeding reasonable limits.