Service Business S Corps and Reasonable Salary from an Accounting for taxes perspective.

[Music] hello today I'm going to talk about s corporations that are service businesses and what we mean by a reasonable salary in the context of self-employment tax planning so I have a previous video you should check out that is about the benefit of being an S corporation or why why you should be an S corporation and talks about why advisors will advise as corporations and the summary of that for those of you saw it and to remind you is that it has to do with minimizing self-employment taxes but that strategy relies on the idea that you have to pay a reasonable salary for the services provided by an owner within the company which still that salary that amount of profit that is treated as an owner salary owners wages is still subject to the Social Security and Medicare taxes so specifically what I want to talk to about today is how this might work in the context of a service business because I see that as particularly tricky when you're trying to come up with a reasonable salary requirement let's face it service providers of various sorts can have a wide variety of wages a wide variety of incomes with you're an accountant or a lawyer or dentist you know some will make less some will make a lot more and so how do we know what a reasonable salary and the service based context is for the purpose of this kind of tax planning well so technically you know when you're looking at the law the law behind it and the requirements that the IRS has and what they have one on in tax court with is that the salary must be market-based so you have to earn a salary the owner has to be paid a salary that would be similar to what they would make doing a similar job with a similar function for some other firm or company in their industry and when the best practice is to do in trying to come up with out is that you already have a process for determining the salary of employees other employees in your company you know you might do some kind of research or some kind of documentation that you put in a file of what you think the market salaries are for other types of employees have your team or yourself do the same kind of research on yourself and use the same sort of documentation so that you can show the process you use to come up with your your salary was the same or seller is the owner I mean it's the same as the process that you would use for any other employee that you're not just making something up to minimize or avoid taxes this topic about what is a reasonable salary for an S corporation owner as I mentioned before this has actually been litigated many times and so there's not a bright-line test for it but we do know we do have some understanding of how the IRS thinks about it and how the courts think about it when they agree with the IRS and the IRS will win against the own against a company as owners they will win on the top on the subject of an owner not paying themselves a sufficient reasonable salary trying to under pay self-employment taxes because they were not paying a reasonable salary the IRS will win on that point when the IRS can demonstrate to base if they can demonstrate that first there is a market rate for the services and that can be substantiated by recruiting firms that are in your industry or geography and second when they can show that the company had sufficient cash flow to pay your market wages so if they can show both things then you are you're pretty you're pretty dead on that point because that means that's the burden of proof that they have to determine that you weren't paying yourself enough and therefore you were just avoiding self-employment taxes now think about the importance of that second criteria you never you don't have to pay yourself wages if your company doesn't make any money right but if the company has sufficient cash flow which is evident when they start making owner distributions in lieu of salary so if your company is making distributions to you of cash and not calling it salary then that suggests that was cash to pay you a salary so you can't you you can't be taking cash from the company and then claiming the company didn't have enough money to pay you a salary or to pay the market rate salary right there are two there are other facts and circumstances that you should consider okay so beyond the two things that I just talked about the two kind of ways that the IRS will establish that you should have paid yourself more the other facts and circumstances to consider particularly in the service based context is you know what what does the evidence about your home business show that your market rate of salary should be so let me give you a kind of a very simplistic example on one end of the spectrum suppose you're a solo management consultant and your income before paying yourself any kind of salary is $50,000 so you're just one person your company your S corporation only has you you're the only employee and that company makes $50,000 for presumably the services you provide the clients right so what should your market wage be in that case well I hate to tell you but it should be $50,000 right because that that's the only logic of it you're deploying your time and services to clients who paid you $50,000 so it's pretty self-evident what the market rate for your time and effort spent in that business was in that kind of context when that happens if your profit before paying you a wage was $50,000 and then you pay yourself a wage of $50,000 it goes through the w2 system you pay the self-employment you pay the Social Security Medicare taxes with your equivalent to self-employment tax and then the S corporation to ducks that wage that it pays you there is no remaining S corporation profit and so you don't have any S Corp profit that avoid self-employment tax in that kind of context so the moral to that story is if you're a service provider and you are a solopreneur and you only make money from clients by providing your services and you have a fairly modest income there's not there's not a lot of advantage to switch over to being an S corporation in fact in the case that I provided there was no advantage to doing that you just created additional administrative burden in the sense that you have to file a separate S corporation tax return from your own personal 1040 so that would be one end of the spectrum right the other end of the spectrum is let's take a consulting firm but let's suppose you hire other consultants you invest in training and process your fees for other people's time your employees time you charge for your employees time and the fees you charge for their time not only pays for their wages but also includes a profit margin for your company so consider the economic proposition there's a lot different right you're making a profit margin off other people's time you're not just making money off your own time in your own services this this has a whole different economic feel to it if you understand that and so let's say that your business profit before paying the owner is $200,000 and you conclude that a firm of that size and in that industry and that particular geography it's it's on average the Managing Partner the CEO of that particular firm might make somewhere around a hundred and fifty thousand dollars in salary for their services to the firm so you peg your w-2 wages 150 thousand so remember the numbers two hundred thousand and profit before your wage your weight is 150 so you take that 150 and that goes to the w-2 you pay the Social Security tax on that you pay the Medicare tax on that and then the S corporation remember two hundred thousand and profit before that 150 and your wages so now there's $50,000 and rainy S corporation problems that $50,000 remaining S corporation profits should be distributable to you without self-employment tax because in that context it appears that you are earning a profit or return from your investment in the business your investment in building the business it's not just from the work that you do in the business like any other employee and so you should be able to avoid or minimize the self-employment tax and not have self-employment tax on that remaining $50,000 in this particular example these kind of examples these kind of scenarios are always based on facts and circumstances so I say you should be able to do that I'm not advising that if you fit some of those facts you should run out and be an s-corporation it really depends on the facts and the IRS can always disagree with me and so you always run the risk that the IRS is analysis is different than mine on something like that I'm just putting out there what I think a reasonable analysis on this would be and what seems to be in line with the court cases that I've seen where the IRS winter doesn't win on this topic and so I think that I think that's a way to think about it but you but we always have to caveat this that these are subjective questions they're not bright line tests you can have an evaluation of what a reasonable salary is using the framework that I've just kind of thrown out there for you the IRS could disagree you could end up fighting about it anyway but life's full of risks right so and business is certainly full of risks so you take risks every day in your business dealing with taxes is one of them so that is what it is bottom line I want the entrepreneurs that I work with to be able to minimize their taxes where appropriate with little risks that they'll be challenged by the IRS and I think that if you follow the pot process that I put forward here you will be on track to that okay well that's it for today or this particular video anyway and I will see you guys later bye now [Music] you [Music]

Channel: TCA

Views: 1,131

Keywords: Accounting, Accountant, Tax, Taxes, S Corporations, Corporate Tax, Income Tax, entrepreneur, small business, Portland, Oregon, Business Tax

Id: 2jOAjatTjE0

Length: 10min 2sec (602 seconds)

Published: Sun Jun 16 2019