officer compensation in S Corporations

Well, it appears I misread the tax law change. Personal Service Corporations (PSC or professional corporations) are in fact subject to the new 21% tax rate. Because they are no longer at 35%, the benefit for converting to an S Corporation may no longer be valid.

Now, this is not 100% certain by the way. The problem is that the writers used the term “amend” versus “strike”. And they amended the original paragraph which contained the tax brackets to state only the 21%. The problem is the next subsection.

That next subsection says that certain qualified corporations pay tax at 35%. Not the highest tax rate but codified at 35%. But, one way to read the change is to strike-through all the language in code section 11(b) and replace it with the 21% tax rate.

I know. YAWN. Except that we are trying to get some planning into place and an S election has to be filed relatively quickly. And the devil to planning is in the minor nuances of things like “amend” versus “strike”.

For want of a nail a horseshoe was lost and because of the loss of one little nail a certain general was executed.

If in fact this reading holds true, I am not convinced a C Corporation should convert to S Status. I actually think that it may be better on net cash flow to be a C Corporation. This is especially true where the pressure is on to pay out disparate compensation to the owner/operators.

Take a medical practice, for instance of 4 doctors, each owning 25% of the outstanding shares. Lets say that each gets to take, in the form of wages, 50% of the net collections on their patients. Then they would look at the profits at the end of the year and issue a bonus with 80% of that pool of money being paid to them.

Under old law, this was important because the medical practice was a PSC under 448(d)(2). As such, any taxable income was taxed at a flat rate of 35%. They didn’t want any amount of money taxed at that level unless it was coming to them. And they sure as heck didn’t want it as a dividend as it would first be subject to 35% corporate tax and then the 15% qualified dividend tax – or 50% overall.

But if in fact the PSC is taxed at 21% then I am not sure that paying it all out in wages is the best approach. That is because the total tax rate for most people on taxable profits in a C Corporation will be the:

Corporate rate of 21%
Qualified dividend rate of 15%
Total tax rate of 36% on corporate taxable income when paid as a dividend
And you eliminate 1.45% Medicare tax

Again, there are more caveats, conditions and restrictions but it should be close to this result because there is a preferential treatment of capital income.

Each business has to be analyzed for its unique interplay between shareholder and company but generally speaking it works out that paying about 80% of the pre-officer compensation profits as wages and then issuing a dividend on the remaining cash (after tax) generates a little more net cash flow to the shareholder/employees. More net cash flow is what this is all about.

The only scenario where being an S Corporation delivers superior net cash flows is when the shareholder/employee doesn’t take a wage: But the difference isn’t so large that it is worth the risk of being audited for unreasonable compensation (and losing).

Lets take a doctor practicing in a PSC where she is the sole shareholder. The Corporation nets $500K of taxable income before shareholder compensation. Under old law, the net cash after all taxes (including payroll taxes) was about $290K if we made sure that all the income was treated as wages to her.

Under the new law, the net cash is about $360K if we treat the income as wages to her. But, we see a slight savings by only paying her $400K in wages and then taking the dividend of the remaining cash after tax.

Why is this important? Because it used to be we had to get PSC taxable income really close to zero – which was challenging at best because you can’t always predict collection patterns. But now, with the tax rate at 21%, the practice does not have to be as accurate, which will reduce the amount paid to accountants to calculate the bonus and we can leave a little more profit in the business to pay out as a dividend and no money is really thrown away.

So, if you are already going through the motions of converting to an S Corporation – wait, you were crazy enough to take tax advice from a blog???? STOP the madness. Talk with your accountant about the right way to approach this. Have your tax professional help you analyze the various options. If you like, I can send you my clunky tax comparison workbook so you have something to play with to help you see the cash savings possible. And if you are looking for a new tax professional to assist you, feel free to write and we will be happy to offer you our best advice.

Have a great day.

Happy Wednesday.

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.

An Example:

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.

Tag: officer compensation in S Corporations

Update on Converting

Consequences