Understanding S-Corp and Reasonable Compensation
The amount of tax savings you can have by being an S-Corp can be very substantial. Even if you’re not really ready for one now, you want to make sure that you understand it so you can pull the trigger at any point you’re ready.
Why You Need to Get the S-Corp Salary Right
1. If it’s too low and you get caught by the IRS, you will pay not only the income tax and the self-employment tax on the low amount but also both on payroll and income tax penalties that cost a lot of money. And the penalties and fines are not tax-deductible.
2. If you get audited for one year, they usually wrap three years up in it. Then they add the income and penalties for those other years.
3. After the IRS catches you, you’re likely now stuck with this higher salary because you did not do the work you should have done in the beginning.
4. Your tax advisor can get slapped with penalties if they don’t do their job.
How to Determine Your Reasonable Compensation Number
- The market approach – based on what you would pay to go out and hire someone to do that job
- The income approach – based on the value of your company and the other companies you might have
- The cost approach – takes into account the different functions that an owner has, and allocates pay based on what they do and the percentage of time in which they do it.
Things to Consider to Make an S-Corp Work
- The compliance part
The IRS is expecting much of you as an S-Corp owner so make sure you realize the actual savings in the S-Corp.
- Have a conversation around this before you decide to pull the trigger.
This is not something you should be doing by yourself. Understand that tax is personal, and so is payroll, distributions, and your business. You’re not the same as the business owner next to you so you can’t just go off based on someone else’s recommendation without getting some personalized advice.
If you want to learn more about getting into an S-Corp as a business owner, check out Episode 042: Understanding S-Corp Reasonable Compensation.