In the tax world, the topic of S-corporations and the salary that needs drawn by the owner(s) of the S-corp is like the wild west. S-corps can be great for self-employed people to save on self-employment taxes. But too many business owners — and their accountants — treat S-corps like a magic wand that can just make taxes disappear completely.
Here’s an example.
Scenario: a friend of mine (who’s not a client) owns a business. The business is a startup that generated about $10,000 of net profit in its first year. The owner took draws of about $10,000 from the corporation during the year.
He asked his CPA about whether some of those draws might need to be called a salary. The CPA told him the following nuggets of “wisdom”:
- You don’t need to worry about taking a salary because you’re too small for the IRS to care about, and
- You don’t need to pay yourself a salary until your net income gets to $100,000. Then you can just do a 50/50 split between salary and shareholder distributions.
Oh my. Where to begin?
- Tax law requires owners of corporations who provide services to the corporation to pay themselves a “reasonable salary.” The “reasonable” part is never defined but the law is quite clear about withdrawals from a business by an owner needing to be called “salary” (up to a “reasonable amount”). (Broadly speaking, see Code Sections 162, 3121, 3306, the regulations under those sections, Revenue Ruling 74-44 and a plethora of court cases).
- There is no such thing as being “too small for the IRS to care about.” It is true that the audit risk is lower for businesses with lower income. But if you’re unlucky enough to get audited, you can’t tell the IRS “I didn’t think I’d get audited” and expect that to fly!
- The CPA’s second statement about not needing to pay a salary until net income is $100,000 is completely wrong, as is his “50/50 split” statement. There is no magical threshold or magical formula. The concept of wages paid to corporate owners is based on how much the owner is withdrawing from the business, what sort of services the owner provides to the business, and determining what “reasonable” compensation is for those services.
I told my friend that his CPA was leading him astray, and that the CPA has no legal basis for saying these things. The only possible basis the CPA could have is “I’ve done it this way with other clients before and the IRS has never questioned it.”
I’m sure the CPA’s small business clients think he’s a hero who’s found the secret sauce for saving thousands of dollars in taxes. But this is one of those “it works great til it doesn’t” situations. Someday the CPA or one of his clients will get burned.
Now … I think there may be ways my friend could legitimately say his salary the first year of operation was $0 even though he took out $10,000. More on that in a future blog post.