Hopefully, you’ve got the picture that the way you save money with this is to have some amount of difference between the total profit and that reasonable salary amount.
If there is a fair amount of spread between the total profit and the reasonable salary, then you can make money on that difference. You can save self employment tax on that difference.
The trick is to pay yourself the smallest amount possible but still have that be reasonable compensation. Everybody wants the formula for that, and there is no formula. You just have to look at all of the facts and circumstances. One of the things that you might look at, is where are those profits coming from? If the profits are coming from your capital investment, or if the profits are coming from the leverage that you have from employees, that would suggest that there could be a greater allocation towards profit and a light allocation towards salary.
On the other hand, if there is no capital investment and there are no employees, you’re just being paid for your hours, that would suggest that almost all of the allocation should be towards salary. You might look at what it would cost to hire someone to do what you do. If you weren’t working for this business, you wouldn’t be required to pay yourself a reasonable compensation.
If you hired somebody else to do what you do for this business, what would it cost? How aggressive do you want to be with that number? Do you want to be conservative or do you want to be very aggressive and have a lower salary?
Again, all of the facts and circumstances go into this. The salary should be a reasonable amount, it should be paid regularly. It’s also a good idea to have minutes that will document your salary policy, backed up by some research. You could do some research at Salaries.com or some other place to help you come to your decision. Also, document that decision. If that’s documented contemporaneously, as opposed to doing all this research when you’re in an audit, it’s going to help. The IRS is more likely to respect your decision that was made back at that time. Those are some things to look at.
What some people do that have S corporations is, they don’t pay themselves a salary throughout the year, then in December, they look at what their profit was and decide what it should be at that time. You can do that. There’s no requirement as far as when you have to pay your salary. That strategy is helpful in that you’ve delayed paying your employment tax an entire year.
If you take distributions throughout the year, you don’t have to pay employment taxes on those distributions. And then you pay out your salary all in December. Well, if you’re a monthly depositor, your employment taxes aren’t due until January 15th. You’ve deferred by a year, the obligation to pay your employment taxes.
But the problem is that if it’s all paid at the end of the year, it doesn’t look like a reasonable salary. I advise my clients to pay their salary on a regular basis, perhaps once a month. You can have a bonus amount at the end of the year, if you like. But, again, all of the facts and circumstances are considered in determining whether this is a reasonable salary. Best to have it a regular amount.
If it’s not a reasonable salary, what can the IRS do?
Well, if you don’t make any distributions, there’s really nothing they can do. The IRS power is to relabel transactions. If you took an amount from your S corporation and you called it a profit distribution or you called it a loan to share holder, the IRS has the power to relabel that transaction as salary. If they do that, then you are arguing with them about whether you are going to have to pay penalties or not on that, because if it’s salary, you didn’t pay the employment tax. Then, there are penalties on that, as well.
If there are no distributions, there’s really nothing the IRS can do. They can’t create a transaction. If your salary is too small, you have an increased chance of audit and an increased chance of paying penalties on that audit. I tried to come up with a way to illustrate this point . . .
of the reasonable salary, and there is a saying that’s been around for years, I didn’t come up with it, perhaps you’ve heard it before. The saying is, “That pigs get fed and that hogs get slaughtered.” The point being, if you’re just a little piggish, your salary is a bit less than the total profit, you can save some money, you can reduce your taxes that way. If you’re a hog and your salary is $0.00 or very close to $0.00, you’re going to get slaughtered, you’re going to get audited and you’re going to pay penalties on that audit.
This graph illustrates that saying. This blue line here represents your tax savings from having an S corporation. As this amount increases here, what we’re increasing as we go to the right is the amount that is distributed as profits as opposed to salary. If you distribute everything to yourself as profit and pay $0.00 salary, you’ve maximized your tax savings with the S corporation. If you pay everything out as salary and you have no profit distributions, then you have $0.00 tax savings from an S corporation. You might as well be an LLC in that example.
This blue line represents the tax savings from being an S corporation, notice that this line is linear. As you increase or decrease your salary or, actually, as this is illustrated increase or decrease the profit distribution, you will affect your audit risk. At this end, when we’re paying ourselves everything out as salary, we have minimized our audit risk. We always have some audit risk, so notice it’s not zero, but we’ve minimized our audit risk there.
As we increase the amount that we take as a profit distribution instead of as salary, you’ll notice that our audit risk goes up slightly. Until we get to this end of the graph, when our salary gets to be very small, we’re taking almost everything as profit distribution. You’ll notice that the audit risk not only is increasing, but is increasing at an increasing rate. It’s really skyrocketing at this end of the graph. This is not the place on the graph you want to be.
Yes, you’ve maximized your tax savings, but you may end up losing that, plus penalties on an audit. It’s much better to be in this part of the graph, where you tax savings exceed your audit risk. You’ve paid yourself a reasonable salary. That salary is not 100% of the profit, so you’ve saved yourself some tax savings with the S corporation.
The self employment tax is not the only thing to consider. You’ve got to take some other things into consideration. The home office deduction is not as inviting with an S corporation as it is with a C corporation, an LLC, or a sole proprietor. With an S corporation many CPAs end up taking it directly against the S corporation income, but the correct way to treat it would be as an unreimbursed employee expense.
That’s a miscellaneous itemized deduction, it’s only deductible to the extent it exceeds 2% of your adjusted gross income. If your adjusted gross income is $100,000, you’re going to lost $2,000 of that deduction. That’s not $2,000 of tax savings. It depends on what tax bracket you’re in. If you’re in a 25% tax bracket, $2,000 of deduction is going to represent $500 of tax savings or tax loss, in this example.
The other thing is that the S corporation may represent more administration for you. If you are a sole proprietor or a single member LLC, as I mentioned before, that’s a disregarded entity as far as the IRS is concerned. Your activity is just included in schedule C of your return. If you’re an S corporation, you have a separate income tax return to complete.
Now, also if you don’t already have employees, becoming an S corporation and adopting this strategy means you’re going to become an employee of your company. So, now you’ve got payroll returns to complete. This doesn’t really matter if you already have employees, all your administration is added by the first employee, so it’s not a big deal to add one more employee. If you don’t have employees, then that’s something you have to consider. That’s extra administrative cost.
There was some pending legislation to get rid of this tax loophole, you might say. . .
The legislation failed. You can look at the statute and see why it failed. The way the statute was drafted, it was going to make the profits of S corporations subject to self employment tax, if the principle asset is the reputation and skill of three or fewer employees, and also, if it was in one of these industries. Well, that’s clearly an attack at small business. Small business is usually the good guy, so they decided to leave this alone. It could come back in the future, though.
The last two slides are just the tax rates for corporate income tax and the married filing joint rates. In the next couple of days we will email a .pdf of all of these slides to everybody, so you’ll have that.
Any questions at this time?
I’m sure there are things that I am forgetting. I guess maybe they’ll come to me, or someone will have a question about it. If there are no more questions, I’m sure someone will come up with a question as I’m wrapping this up, but I just want to point out that we’ve got webcasts coming up.
I know one of the things I forgot about, it was our poll question.
Some of you received a poll question in the past couple days. The poll question was asking, “What do you think is the most tax friendly entity-type for small business?” You can see the results here, we didn’t have too many people vote, we only had five votes, but as always, the LLC was the leading vote getter. Also, although we didn’t have many votes, the sole proprietorship didn’t get any votes.
Now I asked this same question on LinkedIn, and had 50 responses. The results were pretty similar. The LLC was the leading answer, and the sole proprietorship was the loser. Which is very interesting because the LLC, unless you make the election to be taxed as something different, if you’re a single member LLC for tax purposes you are a sole proprietor. So, it’s very interesting that the LLC is always the leading vote-getter for this question and the sole proprietor is always last. I’m not quite sure what the reason for that is, but perhaps your vote would be different now, after the presentation.
The other thing I forgot is that, if you have an LLC or a PLLC and you watched this presentation and thought, “Well, I wish I would have become an S corporation instead.” You don’t need to abandon your entity to create a new S corporation. You can simply make an election with the IRS that your LLC be taxed as an S corporation. You see, there’s no such thing as an LLC tax return, so the IRS has to decide which category you fall in. By default you’re one thing but you can elect to be something different. A single member LLC is treated by default as a sole proprietor. If you have more than one member and you’re an LLC you’re treated by default as a partnership.
That’s another thing I forgot, people might think, “Well, I didn’t address the partnerships.” The slide regarding the LLC and the sole proprietorship really is the same slide for a partnership. Just figure if your share of the partnership’s profits is $100,000, your tax scenario is going to be the same as that slide I showed with the sole proprietor. I’ll go back to it:
Again, LLC, sole proprietor and partnership: if your share of the partnership is $100,000 and you’re in the 35% tax bracket, you’re going to pay this amount of individual income tax, $32,527. All of those profits are subject to self employment tax. You are going to pay $14,000 in self employment tax. You are going to end up with $53,000.
I see Kathleen had a question,” What did you say about the home office deduction and the best entity to use?” What I was saying, is that with the S corporation the home office is not as attractive. With a sole proprietor, a partnership, or an LLC, the home office deduction is deductible 100% against the profits of your sole proprietor, your LLC, your partnership. That is not the case with an S corporation.
With an S corporation that home office deduction is a miscellaneous itemized deduction. So, first of all, you have to itemize. People that itemize have a lot of mortgage interest or in other states they pay a lot of state income tax. Second of all, it’s a miscellaneous itemized deduction, which means you are going to lose the first 2% of your adjusted gross income.
It can work out fine with a C corporation because you can just end up renting to your C corporation, there’s no limitation there. It works out fine with a C corporation. It works out fine with an LLC, sole proprietor, and partnership. It’s not as good of a deduction with the S corporation. You have to weight that along with any potential self employment tax savings that you have with an S corporation.
Catherine is asking, “What is the deadline for the sub S election?” The deadline is March 15th, unfortunately. It has to be made in the first 75 days of creating the entity or the first 75 days of the tax year for which it is to apply. If you want it to apply for 2011, you are supposed to make that election by March 15th. Now, I’ve had some good success making a retroactive election. We have to show reasonable cause on why the election was not made, but the IRS tends to be fairly forgiving in making that retroactive election. But, best to make it by March 15th.
Michelle is asking, “What arrangement would you recommend for a free lance writer?” Well, for a free lance writer, I guess you’d have to look at, I’m assuming you’re not going to have employees. I’m also assuming you’re not going to have a very significant capital investment. You’re going to need to take that into consideration when you decide what a reasonable wage would be. We’d have to take a look at what your total profit is going to be, what you’re going to pay yourself as a reasonable wage.
I never make that determination for the client. You really have to come up with that yourself, what a reasonable wage would be. It’s your industry. You know what people are paid in your industry. You know how aggressive you want to be, or how conservative you want to be with the IRS. We would have to look at that, and if there’s not enough difference between that reasonable wage and the total profit, then an S corporation is not going to work. On the other hand, if that reasonable wage can be a bit less than your total profit, then, yes, even as a free lance writer an S corporation could have some tax savings for you.
Phyllis is asking, “It is my understanding that if you live and work from a rent controlled apartment it is best not to claim home office deductions so you don’t lose the rent controlled apartment. I am in New York City.” I have no idea what the laws are with regard to maintaining the rent control on your apartment, so I’m sorry I can’t help you with that.
Michelle: Right no employees, right on the capital investment being fairly low.
Anne is asking, “What are the potential tax consequences of making an S corporation election several years after the formation as a C corporation? What are the accounting steps?” There are some complicated issues here that have to be looked at. One of those has to do with the retained earnings of the C corporation. The IRS doesn’t want to lose out on that second level of tax. Remember with the C corporation, it paid tax and then it paid a dividend to the owner, and the owner was taxed again on that income.
Let’s say you have a C corporation and for years it was not paying you dividends, or at least not distributing all the retained earnings to the owner, so that this was building up. There’s an issue there if you were to make an election to be taxed as an S Corporation, the IRS wants to collect some of that money there. It is beyond the scope of this presentation to go into what that calculation is, but that’s definitely an issue. There’s going to be some tax consequences of doing that if you have retained earnings built up in your C corporation. Also, there’s something called built in gains in your assets. That could create a taxable event for you if you make the conversion to an S corporation. Those are definitely things you would want to consider.
Again, if you find this helpful please tell your friends about this webcast, which is going to be presented again on May 18th. If you haven’t seen any of our other webcasts and you think those might be helpful, take a look at those. You can see them on the events page at smallbusinesswebcasts.com. We also have small business articles at smallbusinesswebcasts.com. After tax season is over, we’re going to start adding those at a faster rate.
My name is John Huddleston. I’m a CPA for Huddleston Tax CPAs here in Seattle. We help small businesses in the greater Seattle area and across the country in fact, with their tax issues. We do returns for all the states including your federal return. We help with payroll issues, book keeping, tax planning, tax preparation, small business evaluation. Whatever the tax and accounting needs are of small business owners are, that tends to be what we do.
I’d like to thank everybody for attending today. I don’t see any questions from the webcast attendees. We have a small live audience of three people. If you have any questions I’d be happy to answer them. If not, I’m going to end the webcast. Have a good day.