Prior to my going to work in the private sector as first a business development and marketing director for a startup and then a controller, I worked with lots of small business owners. Almost all were structured as S Corporations. And they almost always got in trouble for unreasonable compensation issues.
Unreasonable compensation is an outlier issue. What I mean is that, compensation is considered reasonable if it is likely someone would take that pay package in the real world. With C Corporations, the unreasonableness comes when the owners receive W2 income that is not tied to their job performance and where it drives the Company’s profits to zero. With S Corporations, the unreasonableness comes when owners don’t take wages and instead act as though the business earned all the profit.
XYZ Corp. earns $1.0 Million before payroll to Owen, the 100% shareholder. Owen wants to take all the money out of XYZ, and at the lowest possible tax cost. This is a fair requirement and depending on C or S status, drives a particular approach and potential audit issue.
As a C Corporation, XYZ would not want to say that Owen didn’t earn a wage and issue a dividend. First, XYZ would pay about $350,000 of tax on the $1.0 Million in profits (35%). Then, Owen would receive the $650,000 and pay about $100,000 in personal tax on the distributions (roughly 15%, I rounded up for simplicity sake). So, Owen would net only $550,000 out of $1.0 Million.
If XYZ paid Owen $900,000 in wages, the tax consequences are more involved but lower. First would be the payroll taxes, which is equal to l.2% of the first $150,000 of wages for both Owen and XYZ, plus 1.45% each for medicare on all of the wage, roughly $25,000. Total payroll taxes are $45,000.
Owen hates the idea of writing a check to the IRS in April so he has 35% withheld. The total withholding is $315,000.
And XYZ earned a profit of about $50,000 (since the company’s payroll taxes and the wages paid are deductions) and owes about $7,500.
Total taxes when paid out in the form of wages and driving XYZ’s profits to near zero? $370,000 and Owens net cash received is about $570,000 (rounded of course). And if he took a dividend of the remaining $40,000 net cash in XYZ, he would net almost $600,000, or a total overall tax rate of 40%.
The IRS would prefer that XYZ have much higher profit and taxable dividends to Owen as the combined tax effect is higher.
But what if Owen elected XYZ to be an S Corporation?
Here the consequences are reversed. If, as an S Corporation, Owen took the $900,000 in wages, the tax effect would be the same. But, he personally would pay the tax on the $50,000 at his marginal tax rate – 35%. The total tax bill would be closer to 45% which is not as good as being a C Corporation and paying wages. But, what if he didn’t take a wage?
XYZ would pass the net income to Owen, $1.0 Million. Owen would be taxed at 35%, or pay $350,000. There would be no payroll taxes and there are no corporate taxes so that 35% is all there is. Net cash to Owen is $650,000.
This is a far superior approach as it drives the lowest overall tax bill. It is also fraught with serious consequences as it is likely even more “unreasonable” than the C Corporation paying everything out in wages.
Which brings me to a quick story. A new client came to see us – a dentist. Not surprisingly he was being audited for unreasonable compensation. You see, the good doctor decided to pay himself $12,000 a year and claimed that his practice generated profits of almost $500,000.
His case wasn’t helped by the fact that 2 years earlier he was a sole proprietor and earned $300,000. The year after that he was a C Corporation and paid himself $400,000.
He wanted to know what to do. I gave him two choices. Pay the firm $10,000 to fight with the IRS and most likely lose and have 100% of the profits taxed as wages or pay us $2,500 to negotiate a more realistic figure of about $200,000 for wages.
He wisely chose the later option. We were actually able to make the case that a “reasonable profit” from the business was about $300,000 – taking into consideration the focus on non-dentist services offered and a return on his capital investment. We also convinced the IRS to waive penalties and interest on the underpayment.
If (and possibly a big IF) the tax law changes for pass-through entities, this type of challenge will become even more prevalent. So, if you own a pass-through entity, make sure your professional is looking out for your best interest, not just how much tax can be saved. And if you would like to discuss your tax position with someone, feel free to send me a message. Remember, pigs get fat and hogs get slaughtered.
Have a great day.