By Jason Watson, CPA
Posted Sunday, December 29, 2024

Beyond the reasonable salary theories and jumping off points, there are some things to keep in mind as Officer Compensation is determined.

Social Security

As mentioned before, the 35-40% salary is just a jumping off point. There are several factors that need to be considered and they can be competing. For example, you might want a higher salary to add to your Social Security basis. We demonstrated this in an earlier chapter, and a snippet of that is reprinted here.

The maximum Social Security benefit for 2021 is $3,957 per month for those who delay until age 70, or $3,135 for those who start benefits at full retirement age (FRA). Using SSA.gov’s calculator, at $60,000 in salary at an age of 50 your benefit would be $1,955 at age 67 in today’s dollars. A $100,000 salary would have a benefit of $2,675. Yes, we need to update this data but the illustration remains substantive.

Whoa! Look at those deltas between salary and benefits right around $90,000 to $100,000 in salary. This would suggest that salaries above $90,000 have a steep diminishing return on increasing SSA benefits. Or, said differently, salaries below $90,000 have a good retirement benefit for your salary buck. Additionally, consider that paying $140,000 costs about $7,500 in additional taxes without a corresponding strong future benefit ($50,000 x 15.3%).

Do you pay yourself $90,000 just to get the most SSA benefit relative to the increased Social Security and Medicare taxes? Consider this-

If you paid yourself $60,000 instead of $90,000 you would lose $612 in SSA benefits per month, or about $146,880 assuming 240 months (or 20 years of life remaining at 67 years old).

However, you would save $4,590 in Social Security and Medicare taxes per year with a $30,000 lower salary. If you worked for 30 years, and those tax savings earned 5%, you will have over $320,000 accumulated. Accumulated wealth can also be transferred or spent, where future benefits are just that- future benefits and not money in the bank.

Again, something to consider.

Maximize Your 401k Contribution

You also might want a higher salary to maximize your i401k plan or solo 401k plan. You can contribute up to $23,500 (for the 2025 tax year) plus $7,500 catch-up if 50 or older. Therefore, if you are 50 years old you might want your salary to be at least $33,100 (this leaves room for your portion of Social Security and Medicare taxes). There are instances where a $350,000 salary (for the 2025 tax year) might be the best solution given age-based profit sharing and defined benefits pensions.

Oftentimes, these small business retirements plans are added to the traditional 401k plan to “turbocharge” them. It seems crazy to want to pay a $345,000 salary when one of the resounding themes is to have a low salary, but there could be significant tax savings. See Chapter 12 which is dedicated to self-employed retirement plans for more details or this link-

wcginc.com/turbo

Health Insurance Floor

Another competing interest, or at least a factor, is health insurance and HSA contributions. Generally, you must have income subject to Social Security and Medicare taxes that are equal to or higher than your health insurance premiums. Huh?

Let’s say you have not elected S Corp tax treatment on your LLC, and your LLC has a net ordinary business income after expenses and deductions of $10,000. This is subject to self-employment taxes (Social Security and Medicare). If your health insurance premiums are $15,000, only $10,000 would be deducted as self-employed health insurance (a direct adjustment to income) and the $5,000 remainder would be deducted on Schedule A subject to those limitations.

Same thing in S Corp land. If your self-employed health insurance is $15,000 per year, you must pay yourself at least $15,000 in salary to be able to fully deduct the premiums as self-employed health insurance. Your $15,000 salary is subject to Social Security and Medicare taxes just like your $10,000 LLC income above.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Calculating reasonable S Corp officer compensation and shareholder salary is like nailing Jell-O to the wall. If you want to eliminate (not just reduce) the risk that the IRS will disagree with your calculations, you can pay out your entire economic benefit from the business in shareholder salaries. That seems silly, right? This would make the S corporation’s efficacy zero. How do we approach this then?

As you go through this chapter, keep two simple things in mind. First, the word reasonable has an antithesis, and can be defined in the negative. In other words, while it is hard to define reasonable, we can confidently define what is unreasonable. Paying $5,000 in shareholder salaries on $100,000 in net business income (profits) for a one-person consultant S Corp is unreasonable. Most people would agree with that sentiment.

One more stab using different words to convey this concept- rather than eclipsing the reasonable threshold, perhaps view determining an S Corp salary as not wanting to trip the unreasonable wire.

To be certain, the IRS and others use the word reasonable, but they too cannot define what is precisely reasonable and then what is precisely not reasonable. While the sparring of reasonable and unreasonable presents as a binary situation with a winner and a loser, it is anything but binary. As such, we are back to hammers, nails and Jell-O.

Second, we encourage you to embrace the fluidity of reasonable shareholder salary. If you like straight lines and clean garages, this will bug you a bit. At the same time, when you always have the option to pitch an argument with reasonable salary calculations, or anything else in life, that puts you in a favorable position. So, you’re saying there’s a chance. Yes! We are!

This is our favorite chapter not because we like Jell-O shots, because we certainly do at any age or life stage, but because it is the most cerebral S Corp topic and the one we get asked about the most.

In this chapter we will review-

• IRS Stats
• IRS Revenue Rulings and Fact Sheet 2008-25
• Tax Court Cases
• Risk Analysis, Investor Perspective
• Assembled Workforce, Developed Process
• Converting from W-2 to 1099 (revisit the risk analysis)
• RCReports, Risk Management Association (RMA), Bureau of Labor Statistics (BLS) and Salary.com
• Rules of Thumb, Jumping Off Point
• Multiple Shareholders, Spouse Salary, and
• Additional Considerations (Section 199A QBI, 401k optimization, etc.)

Here we go!

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Among several things, the Tax Court and the IRS will attempt to support a reasonable salary based on your peers and colleagues. They will use an expert who specializes in vocational valuations, and this person might use Risk Management Association (RMA) and Bureau of Labor Statistics (BLS) data, including local and regional data.

Our previous real estate agent benefited from this type of valuation since his S corporation earned significantly more than the average real estate agent’s salary. But what if the opposite was true? So, instead of earning $231,454 and only paying out $100,755 in salary, what if you earned $110,000. Would you have to pay out $100,755 in salary just because you are a real estate agent in an area where other agents earn $100,755?

The answer is a true accountant or lawyer response- it depends. There are several factors that mitigate the calculus. Perhaps you work part time. Perhaps you simply are not as good as your peers. Perhaps you focus on a different type of customer. Review the previous IRS and Tax Court laundry lists, and as you go through each item ask yourself if you could safely use it to justify a lower salary than your peers- we bet you can find several instances.

Statistics attempt to homogenize a population so we may draw correlations and eventual conclusions. Certain professions that appear to be slam dunks are not as they appear. Attorneys and accountants come to mind- we know some attorneys that make $150,000 a year while others make $450,000. It is very tough to jam these two square pegs into the same round hole. Accountants, same thing. IT consultants, same thing. Even physicians doing the same line of work (such as anesthesia) range between $80,000 and $400,000. Same work, at least on paper, yet wildly different incomes!

There is another lesson to be learned here. As your S Corp income increases, the reasonable salaries paid to the shareholders do not necessarily increase on a pro rate basis. In other words, if you peg your salary at $60,000 and that is supported with labor data, your salary does not double just because your net business income (profit) in your S corporation doubles. Your salary is based on you, and the data surrounding you. Yes, the courts look at distributions and net income, and Yes, your salary would probably be increased if your net income doubles, but it is not tethered in a lockstep, $1 for $1 pattern (more on this in a bit).

Salary.com and the like also do a great job of compiling labor data. RMA and BLS is going to be much more authoritative in court, but RMA (as an example) requires an expensive subscription and is usually reserved for valuation experts who rely on their data multiple times to justify the cost.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

As alluded to earlier, the business’s ability to earn revenue without the direct involvement of the owner(s) can be huge. Consider an actor or an on-air personality (WCG has a handful of these clients). Would revenue continue after the owner stopped working?

Assembled Workforce

For example, you start off as a one-person engineering firm earning $150,000 net ordinary business income (profit) after expenses and deductions but before shareholder salary. You pay yourself $65,000 and pocket $85,000 as shareholder distributions. Done.

Time moves along, and you’ve hired eight other engineers and they are paid $90,000 each but contribute $60,000 to the bottom line of the business (using the $150,000 number above as a proxy). Even if you increase your salary to $150,000, you still have $480,000 ($60,000 x 8) available for shareholder distributions.

Yes, this is overly simplified, but it illustrates a huge point. Should you sell your engineering business to an investor, he or she would hire another person for $150,000 to run the business and use the remaining $480,000 as a return on investment because of the assembled workforce effect. You are no different. As mentioned several times throughout our book, you are both employee and investor when you own and operate an S corporation. You must consider both interests, and at times they are competing.

Using the example above, the employee and investor are the same person when you own it, but we must always bifurcate these worlds because they are not directly related to each other in terms of the split. Granted, if you saw your boss (the investor) making $480,000 perhaps you would ask for more than $150,000 to run the business. Then again, if $150,000 is the going rate, that is what your boss will pay you regardless of what he or she makes as a return on investment.

Developed Process

Using our previous question about the actor or on-air personality, would your answer change if this person developed a process such as podcasts, videos, merchandising, likeness licensing, etc.? Of course, it would. An actor who earns $300,000 from acting and $200,000 from other sustainable sources is much different than the surgeon who earned $500,000. As such, reasonable S corporation salaries would certainly vary.

Here’s another one to make you go hmmm. How about a financial advisor who has been in the business for 25 years? A lot of their present-day income is truly deferred earnings from multiple decades of hard work. Sounds more like an investment, doesn’t it? And as we’ve discussed, a return on an investment is more of a shareholder distribution argument than a reasonable salary argument.

We could go on and on with this.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

We raise the risk issue throughout our chapter on reasonable shareholder salary, but let’s touch on it some more. Please recall that shareholder distributions are financial rewards to the investor. While the detached abstract investor and the employee are the same person (you), it doesn’t change the theoretical demands of an investor. When a business valuation is calculated, discretionary cash flow is determined and then a risk premium is assigned to it. Simply stated, cash flow divided by risk (capitalization rate) equals value.

Here is a sample build-up method to determine risk-

Company specific risk includes things like (just naming a few)-

• Operational History

• Volatility of Earnings

• Product or Service Concentration

• Customer Concentration

• Ability to Affect Pricing

Look at this list again, and compare it to your business. Are you relatively new? Are your earnings volatile (such as real estate)? Even 10% swings could be considered volatile. What would happen if Walmart stated in their shareholder meeting that they were predicting being off 10% next year? Heads would roll.

What about your service concentration? Think of an attorney- they pass the bar exam as a generalist, but quickly become a specialist (and forget all the other law he or she learned). Can you take your current skillset and find a whole new gaggle of customers in a different industry or sector? Maybe. Maybe not.

What about customer concentration? Are you a 1099 contractor who has one client who also happens to be your former employer? Huge risk, right? Heck, they’ve already fired you once.

What is your ability affect pricing? Usually none. Perhaps Apple but probably not you the mighty solo operator holed in your home office.

What are we getting at here? Would you consider a 19% return on investment (see table above) to be high? Not sure? Walk into your financial advisor’s office and ask for investments that only return 19% or higher. After the laughter, he or she might loosely show you some private equity investments or other syndicates that might return 19% if everything, and they mean everything, goes right.

What does all this mean? This means that any small business owner assumes a ton of risk, and that risk should demand a higher return on investment. In other words, a higher return on investment should demand higher shareholder (investor) distributions, and therefore lower shareholder salaries. This is a like a teeter-totter.

The entire economic benefit of the business can only be paid out in salaries and distributions (and perquisites or what we call “perks”). As such, if distributions are higher because of investor risk and the subsequent demand for more return on investment to meet the risk profile, then salaries must be reduced.

By Jason Watson, CPA
Posted Thursday, October 7, 2021

The tax court has provided some guidance over the years in several well-known cases. Here is a quick reference list, and later we’ll dive into the finer details-

Ulrich v. United States, 692 F. Supp. 1053 (D. Minn., 1988)

Sole shareholder of an accounting firm whose only income was dividends. The court held “Under both the weight of the case law and under the treasury regulations, a corporate officer is to be treated an employee if he renders more than minor services.”

Spicer Accounting v. United States, 918 F.2d 90 (1990)

Spicer was the only accountant working for the firm and it was owned 50-50 with his wife. He only received dividends, and claimed to donate his services to the S corporation. The court held “The Federal Insurance Contributions Act and Federal Unemployment Tax Act both define ‘wages’ as ‘all remuneration for employment… that the form of payment is immaterial… [therefore] the only relevant factor being whether payments were actually received as compensation for employment.”

Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012)

No relation to Jason Watson or WCG CPAs & Advisors! (Jason is a bit crazy from time to time, but not this cra-cra). In this case, David E. Watson was an accountant in a firm he owned. He drew a salary of $24,000 even though the firm grossed nearly $3 million in revenue. Watson was a Certified Public Accountant with advanced degrees. The 8th Circuit Court ruled that a reasonable person would consider the dividends paid to Watson to be “remuneration for services performed” as opposed to a return on investment. To support its position, the IRS successfully asserted that the $24,000 shareholder salary was not enough to support Watson’s lifestyle. As such, his dividends were reclassified as wages and the firm was assessed huge employment taxes plus penalties and interest.

JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (District Court, North Dakota, 2006)

Dahl, an accountant and sole shareholder, paid himself a small salary. The IRS hired a valuation expert who used Risk Management Association (RMA) data to determine what other accountants were paid for similar services. The RMA data was damning enough, however what really sent this case over the edge is the Dahl paid himself less than his staff including clerical positions. Admins cannot make more than you.

These darn accountants are out of control! Here are couple of “wins.”

Davis v. United States, 1994 U.S. Dist. LEXIS 10725 (District Court, Colorado, 1994)

A husband and wife team owned a corporation. The husband worked elsewhere and the wife performed clerical duties (12 hours per month). Her accountant said her services were worth $8 per hour. The IRS did not challenge the value of the time commitment and therefore Davis won this case because the wife was able to prove her minimal hours.

Sean McAlary Ltd. Inc. v. Commissioner (Tax Court Summary Opinion 2013-62)

In a recent tax court case, the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in distributions, and avoided self-employment taxes (mainly Medicare) on that portion of his income. Then again, this makes sense. Real estate oftentimes sells itself thanks to the internet, and the real estate agents are merely facilitators. In other words, the actions of the real estate agent were not solely responsible for $231,454 in income.

There are two tests that tax courts have used in the past. In Label Graphics, Inc. v. Commissioner, Tax Court Memo 1998-343 which was later affirmed by the 9^th Circuit Court in 2000, the court came up with-

• The employee’s role in the company.

• A comparison of the compensation paid to similarly situated employees in similar companies.

• The character and condition of the company.

• Whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.

• Whether the compensation was paid pursuant to a (1) structured, (2) formal, and (3) consistently applied program.

In Brewer Quality Homes, Inc. v. Commissioner, Tax Court Memo 2003-200, the court re-iterated several points from another federal court case (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))-

• The employee’s qualifications.

• The nature, extent, and scope of the employee’s work.

• Size and complexity of the company.

• Comparison of the employee’s salary with the company’s gross and net income.

• Prevailing general economic conditions.

• Comparison of salaries with distributions to stockholders.

• Compensation for comparable positions in comparable concern.

• Salary policy of the company as to all employees.

• Amount of compensation paid to the employee in previous years.

Similar to IRS Fact Sheet 2008-25 no single factor controls. It really is a preponderance of the evidence as civil courts like to say. Tax court judges will go through these lists, depending on the case and the jurisdiction, and will apply the facts and circumstances to each of these factors, and essentially make a list of plusses or a minuses.

For example, the criterion might be “Payment to non-shareholder employees.” The tax court will analyze the evidence to determine the plus or minus. Let’s say the S corporation owner provides evidence that her star employee is the rainmaker and therefore the employee’s salary including bonuses exceeds the S corporation shareholder. Let’s also say that the tax court finds this argument to be compelling. This would a “plus” for the S corporation owner since the criterion of “Payment to non-shareholder employees” favors the S Corp shareholder.

Continuing with this example, assume the owner had $300,000 in net income after expenses, but only paid $30,000 to herself as an S corporation salary. The IRS and tax court would place a “minus” next to the “A comparison of salaries paid to sales and net income” criterion as they did in K & K Veterinary Supply, Inc. v. Commissioner, Tax Court Memo 2013-84.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

In 1959, IRS Revenue Ruling 59-221 held that amounts of S corporation undistributed taxable income which are required to be included in each shareholder’s gross income do not constitute net earnings from self-employment to shareholders. However, in 1974, IRS Revenue Ruling 74-44 stated that “dividends” paid to shareholders will be recharacterized as wages when such “dividends” are paid to shareholders in lieu of reasonable compensation for services performed for the S Corp. The word “dividends” is in quotations because in reality we call these shareholder distributions, but in 1974 they referred to them as dividends.

This makes sense. Dividends being used to pay for services are truly wages. If Google or Amazon pays out a dividend to its shareholders, it is considered investment income. If your S corporation does the same thing to its only shareholder without an accompanying shareholder wage, then it is considered self-employment income and subject to the gaggle of taxes with that type of income.

Also, consider the words “in lieu of reasonable compensation.” This is to suggest that if shareholder salary is not processed and only shareholder distributions are paid, those distributions will be recharacterized as shareholder salaries. In other words, paying reasonable shareholder salaries protects shareholder distributions from being recharacterized as salary. But keep on an eye on that word “reasonable.” It is the kicker.

Moving on… There are several factors to consider when coming up with a reasonable salary to pay shareholders. The IRS through Fact Sheet 2008-25 released the following laundry list (last update was in 2008 when Flo Rida was singing Low… apple bottom jeans, boots with the fur, the whole club was looking at her. How time flies!)-

• Training and experience.

• Duties and responsibilities.

• Time and effort devoted to the business.

• Dividend history (IRS nomenclature, really this should be shareholder distributions- however back in the day it was C corporations who later elected to be taxed an S corporation, so dividend history still has some historical merit).

• Payments to non-shareholder employees.

• Timing and manner of paying bonuses to key people.

• What comparable businesses pay for similar services.

• Compensation agreements.

• The use of a formula to determine compensation.

Clear as mud. This is the best the IRS can come up with? What is even more frustrating or perhaps embarrassing is that this list was the final draft after probably several meetings and rough drafts. Having said that, this is how our tax system operates in many ways- leave lots of wiggle room for interpretation so the law and the standards can evolve to meet the needs of today.

This list actually has two applications. Since C corporations have had a historically high tax rate including being double-taxed, many small C corporations want to drive corporate income close to zero by paying high salaries. The IRS and the Tax Court will use this list to say your salary is too high as a C Corp.

Conversely, S corporations want to increase corporate income (and available cash for shareholder distributions) by paying small salaries. The IRS and the Tax Court will talk out of the other side of their mouths by using this list to justify a higher salary. Yes, they get to have it both ways.

Here is a link to IRS Fact Sheet 2008-25-

wcginc.com/8247

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Determining a reasonable salary is the hardest part of running an S corporation. What the heck do I pay myself? Before we get into that, let’s discuss why shareholder salary needs to be just above bar napkin quality and just below NASA precision.

Scattered throughout this book we’ve stressed that the only tax savings an S Corp provides is the reduction of self-employment taxes, and in the case of shareholder wages we are talking about Social Security and Medicare taxes (payroll taxes). When your business pays you $10,000 in shareholder wages, 7.65% is withheld from your paycheck for the employee’s portion of payroll taxes. This is broken down into 6.2% Social Security tax and 1.45% Medicare tax. The business also must pay 7.65% for a combined percentage of 15.3%. Since the business deducts its portion of payroll taxes, the effective tax rate is 14.1%, but we’ll use 15.3% since that is the big number everyone knows.

Therefore, a $10,000 shareholder salary costs you $1,530 in additional taxes beyond income taxes. Said in a different way, if you pay yourself $50,000 when $40,000 could have been a reasonable shareholder salary, you just wasted $1,530. Even a $5,000 delta equates to $765.

Truth be told there is some philosophical issues with the reasonable salary element where your labor is the only material income-producing factor for the business. Some would argue that all the S Corp’s income should then be considered shareholder wages and subjected to Social Security and Medicare taxes, since if you died the business would die. Do we see this “loophole” being re-defined and shrinking over the next several years? Yes. But at the same time, we say let it ride until we can’t use it. The IRS and Congress move at glacial speeds- let’s worry about next time, next time.

Conversely, there might be times where your business would continue without you. When WCG performs business valuations, especially in divorce proceedings, we assign a value to goodwill. We do this by taking a number called seller’s discretionary cash flow (SDCF) and we subtract the cash flow that is derived from tangible assets (cash, equipment, etc.). This leaves us with a theoretical number that is considered goodwill which can be used as a proxy to determine your “value” to the business.

We further tease out personal goodwill and enterprise goodwill since in some jurisdictions personal goodwill is not marital property. This might seem like an odd tangent, but a similar argument can be made for a business that does not rely on you. One great example is a financial advisor that has a small team supporting him or her- typically the fee income continues well into the future without the direct involvement of the advisor (enterprise goodwill). In this situation, an argument for a smaller salary could be warranted since enterprise goodwill exceeds personal goodwill.

Consider this-

Of course, this is all theoretical and is open to debate, but you get the idea.

Take this one step further. What would an investor be willing to pay a person other than you, yet who is also capable of running the business? Perhaps your contribution to the business was developing procedures and workflows to make it hum, and someone with less skill and experience can do the same work and produce the same results. Just a thought as we head into all this.

Naturally, a lower salary to you results in a higher rate of return for the investor. We could also look at the earnings generated from capital investments such as machinery or internally generated assets, and other non-owner employees versus shareholder labor. Think of that software developer from the previous table. We digress here but explore this more in a bit.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Let’s jump right into some numbers first before going through reasonable S Corp salary theory developed from IRS revenue rules and Tax Court cases. The following table is a summary generated from IRS statistics on S corporation tax returns for the 2017 tax year (we will update next go-around, but this remains stable and relevant for discussion).

First some quick observations. Officer compensation is added back to net income to determine officer comp as a percentage of net income after expenses (profit). Next, this is all industries from capital intensive manufacturing to personal services business such as attorneys, doctors, consultants, engineers and accountants. More data to follow in a bit.

Also, this includes S Corps who lost money, and whether they lost money and continued to pay a reasonable shareholder salary (Officer Compensation) is unclear. In other words, if losses were teased out would Officer Compensation be reduced as a percentage of net income? We cannot quickly determine from the IRS data.

Here is one more nugget to chew on. As compared to 2013, the Officer Compensation as a percentage of Net Income (far right column) has decreased 2-3% for each Annual Receipts category.

The following tables are from 2013. The IRS has stopped bifurcating gross receipts per return on an industry basis alongside groupings of gross receipts. While this data is seemingly stale, it adds more perspective to the previous table. First one is $100,000 to $249,999 in gross receipts-

And now for $250,000 to $499,999 in gross receipts-

The following table is from 2017 data (again, we will update next go-around) but it is aggregated regardless of gross receipts-

Some comments-

• Certainly, aggregating all businesses regardless of gross receipts skews the data. As businesses grow, they have an assembled workforce who contribute to the revenue more than the officers (shareholders).

• The IRS had a footnote on Health Care (and other industries) where because of privacy concerns, certain data is not reported. Additionally, Securities, Finance is not the same as Finance and Insurance (close, but not the same).

• Check out Manufacturing and Retail as compared to Professional, Scientific and Health Care. Professional, Scientific and Health Care industries will generally have officers (shareholders) who are more impactful to the overall revenue generation and operations of the business.

• Professional, Scientific has the second lowest average officer compensation, but the second highest as a percentage of net ordinary business income after expenses and deductions. This would suggest this sector is highly fractured with several smaller businesses (all S Corps however).

• Do not read too much into the Officer Compensation Percentage of Net Income figures. These are illustrative only, and do not purport to be a rule or recommendation.

There you go. Remember that Officer Compensation includes all fringe benefits such as self-employed health insurance and HSA contributions, and it might be influenced (increased) by those who want to maximize 401k deferrals, profit sharing plans and defined benefits pensions / cash balance plans. In other words, people with more discretionary cash wanting to defer taxes might increase salaries to do so.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Keeping your salary low is what drives the savings in an S corporation. Recall that $10,000 in salary costs you about $1,530 in payroll taxes. However, through the IRS Fact Sheet and several Tax Court cases, the assignment of reasonable shareholder salary becomes qualitative in relation to several factors such as your role and qualifications, and the relationship to net income and distributions (just to name a few).

Labor data such as Risk Management Association (RMA) and Bureau of Labor Statistics (BLS) including RCReports can be hit or miss. Homogenized populations cannot definitely tell the IRS or the Tax Court what you should be paid. It could be a tool in your toolbox, or it could be one of the many nails in your coffin.

Don’t forget the assembled workforce effect and return on investment arguments.

Also recall that self-employed health insurance and Health Savings Accounts (HSA) add to your Box 1 wages on your W-2. Let’s say your reasonable salary is $60,000 and you pay $12,000 in health insurance premiums. You would pay yourself a $48,000 salary but your W-2 Box 1 and Line 7 (Officer Compensation) on your S corporation tax return would show $60,000, but only $48,000 is subjected to Social Security and Medicare taxes.

One of the best ways to win an argument is to not have the conversation in the first place. The IRS is focused on S corporations who do not pay any salary, or who pay a ridiculously low salary. For them, it is an easy analysis. Line 7 versus Line 21 of the S Corp tax return (Form 1120S). They can also look at the K-1, Box 1 (ordinary income) and compare this to Box 16, Code D (distributions). There’s probably an app for that.

IRS scrutiny will only increase over time, but they also want winnable cases. The low hanging fruit is the S Corp without any reasonable shareholder salary. Why go after someone who is paying themselves $50,000 in salary just to settle on $60,000 after negotiation? An extra $1,530 in the IRS pocket for arguably a tough audit might not be worth it to them. This scenario is contrasted to the person who pays themselves $10,000 and it should be $60,000. There’s some cash in that IRS challenge!

There is a calculated risk when determining reasonable compensation for S corporations. You can eliminate the risk by paying yourself 100% of the net business income but then again that completely defeats the purpose of an S Corp. You can pay yourself 0% and wait for the audit. Or… ideally… you can operate in the soft middle.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

There are plenty of professions that have great data from the Bureau of Labor Statistics (BLS), Risk Management Association (RMA) or RCReports. But let’s say your job is some odd-duck, whacky thing for which comparable data doesn’t exist. Where do we start quantitatively? At the end of the day, we need a number!

One argument that we and others have made is the concept of 1/3, 1/3, 1/3-

• 1/3 paid as shareholder salary, plus

• 1/3 retained for expenses (if necessary, otherwise flushed out at end of quarter), plus

• 1/3 distributed as return on investment (distributions)

Where the heck did we get this? A rule of thumb for service trades or businesses such as accountants, attorneys, consultants and the usual suspects is to bill three times the salary. For example, if WCG pays a CPA $100,000 per year we hope to bill $300,000. 1/3 of this goes to salary, 1/3 goes to expenses and 1/3 goes to Jason’s new boat in a land-locked state. Most professional firms should have net profits of about 30 to 35%.

Sidebar: This is why CPA firms sell for about 1.0 to 1.1 times gross revenue. This translates to a 3-year payback period at 100% retention or about 5-6 years with the usual 60% retention. This is an acceptable return on investment as compared to other investments and the accounting industry. Remember the rule of 72? Divide 72 by the rate of return, and that is your payback period (or the time it takes to double your money… same thing). 72 divided by 6 is still 12% which is not super great given the risk (oh well). We digress…

Even if your profession is easily teased out from labor data, this 1/3 concept can still be used. The middle 1/3 above is allocated to expenses- why should you be penalized for running a leaner, meaner firm than the bloated clowns down the street?

Using the 1/3 concept is just a starting point- since we have to start somewhere, using a mathematical formula makes it easy. From there, similar to the “plus” and “minus” approach by the IRS and Tax Court judges, we massage this salary to be reasonable for you and your business’s situation.

Using the 1/3 concept is just a starting point- since we must start somewhere, using a mathematical formula makes it easy. From there, and similar to the “plus” and “minus” approach by the IRS and Tax Court judges, we massage this salary to be reasonable for you and your business’s situation.

What does WCG CPAs & Advisors do?

• If we don’t have good data from BLS.gov or other resources, and

• RCReports is not available, and

• We are not affected by other influences (max out 401k, defined benefits pension, etc.), then

• WCG starts off at around 35% to 45% depending on the profession (based on observations), and then

• Massages the number with the client using IRS guidance.

From there, we-

• Create a payroll plan with monthly Processing, and

• Create a tax plan for the household to project tax obligations (holistic tax planning), and

• Increase income tax withholdings to land on tax neutrality for April 15 (no surprises) and try to avoid estimated tax payments, and

• Re-tweak May, June and July, maybe in November

We expand on this in the next chapter. Yay!

By Jason Watson, CPA
Posted Thursday, November 2, 2023

So, you are bumping along and one day your employer decides to convert you from a W-2 employee to a 1099 contractor. Fired on Friday. Same duties on Monday. Aside from this being a load-shedding sham that the IRS and most states believe to be an end-around, several large businesses continue to reduce their workforce in favor of contractors.

You say, no problem, and eventually create an LLC taxed as an S corporation. Now what? Do you peg your salary to the same salary you had before? Hardly. Labor burden rates for businesses can vary from 1.4 to 2.0. What does this mean? This means if a business is paying you a $100,000 salary, your actual cost to the business might be as high as $200,000. Why?

Health insurance, dental insurance, paid time off, vacation, sick pay, holiday pay, payroll taxes, workers’ compensation insurance, disability, group life insurance, office rent (smaller workforce smaller office footprint), overhead, etc. Yeah… read that again. There are a ton of direct costs that gets tacked on to you as an employee. Don’t forget profits too. No wonder the business just converted you from W-2 to 1099. Mo’ money! Just not for you.

How does this factor in the reasonable salary conversation? Let’s say your business’s labor burden rate is 1.8 which is not far off most big, fat corporations. This would suggest that a $100,000 salary costs the business $180,000. If you are paid $100,000 as a contractor (which would be a crummy deal), then your relative salary could be $55,000. You shouldn’t get penalized if you run a leaner operation than your former employer.

What about the risk of this new arrangement? As a shareholder in an S corporation, you are assuming a ton of risk- equity risk, industry risk, small business risk and business-specific risk. If we perform a business valuation where the business has a singular client, the risk of the future economic benefit (income stream) is huge.

As mentioned elsewhere, as risk increases, we as the investor demand a higher rate of return, or as the shareholder, increased distributions. Makes sense, right?

Mini recap- labor burden rate plus increased risk of singular client can suggest a lower salary than the old W-2 job. And… being converted is not a bad deal- business car, your own 401k, various other deductions that were mostly unavailable to you, business casual means PJs, etc.

By Jason Watson, CPA
Posted Thursday, November 2, 2023

For several years now, WCG CPAs & Advisors has leveraged RCReports or Reasonable Compensation Reports which is a consulting firm out of Denver, Colorado. They send out a survey to you which asks a bunch of questions about qualifications, time spent on various tasks, regional data, etc. From there, and in their words, “RCReports synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and our EXCLUSIVE database of wages to accurately assess Reasonable Compensation for S Corp, Small & Closely Held Business Owners.” Cool!

You can view a sample here-

wcginc.com/8257

If you visit this link and read the report, RCReports does a wonderful job coming up with a number and then putting a bunch of data behind it. The report looks official and uses sources; this is a critical consideration since reasonable compensation is such a squishy thing. In other words, the IRS might challenge your reasonable S Corp salary much like a mall cop with a badge but no gun, and certainly no evidence. When you roll up with a 7-page document that has numbers, data and sources scattered about, it is super hard for the IRS to say No. For lack of better evidence, the IRS would be forced to use your evidence.

Two more considerations with RCReports. They use a typical appraisal approach similar to home appraisals, business valuations, etc. using cost, market and income approaches. This is pretty cool, and lends additional credibility to their work.

Here is a blurb from their website about the approaches-

Cost (AKA Many Hats Approach)
Cost Approach (AKA Many Hats Approach) – The Cost Approach breaks the duties of the business owner into its components such as: company administration, accounting, finance, marketing, advertising, engineering, purchasing, etc.

The Cost Approach breaks down the time spent by the business owner into the various duties performed and quantifies the amount of time devoted to the different duties. Next, salary surveys are used to determine a comparable wage for each job duty performed by the business owner, then added up to arrive at the total “cost” to replace the services of the business owner.

The Cost Approach generally works best for small businesses where the business owner provides multiple services for the business (wears many hats).

Market (AKA Industry Standard Approach)
Market Approach (AKA Industry Standard Approach) – Compares the business owner’s compensation to compensation within the same industry. The market approach focuses as much as possible on the owner’s business and the specific position being analyzed (often the CEO or General Manager who also owns the business). The question to be answered is: How much compensation would be paid for this same position, held by a non-owner in an arms-length employment relationship, at a similar company?

The Market Approach generally works best for medium and large businesses where the business owner provides only one duty: management of the business.

Income (AKA Independent Investors Test)
Income Approach (AKA Independent Investors Test) – Seeks to determine whether a hypothetical investor would be satisfied with their return on investment when looking at the financial performance of the business in conjunction with the compensation level of the owner.

The income approach can only be correctly applied when the Fair Market Value (FMV) of the company is available for each year that compensation is examined.

The rationale behind the Independent Investor Test is that investors pay employees to work to increase the value of the assets entrusted to their management. A high rate of return indicates that the assets’ value increased and that the employee provided valuable services. Thus, if investors obtain returns above what they should reasonably expect, an employee’s salary is presumptively reasonable.

The Income Approach generally works best when there is no comparability data available.

The other consideration is that just because RCReports comes up with a salary does not mean you must pay that salary. There might be circumstances which would drive down a reasonable salary such as rapid growth, unsteady earnings, etc. There might be circumstances, such as 401k and other external reasons, to increase your salary.

Recently WCG CPAs & Advisors had a foot and ankle physician group in Rhode Island complete two different RCReports interviews to determine a reasonable salary for their S Corp, and the results are worthy of further discussion. The first draft yielded a shareholder salary of $193,762 yet the second draft returned $112,728. That is an $81,000 difference!

What changed? Good question. In the updated report, all three components changed-

• 2,080 hours went to 1,820 which is either 35 hours a week or just over 45 weeks per year.

• Time spent went from 80% to 75% when the S Corp shareholders dug a little deeper into their time allocations.

• Proficiency went from above-average to average. This was HUGE! It changed the hourly rate from $104 to $66.

Therefore, think of the pinball bouncing around in your RCReports pinball machine. The first bounce was reducing the hourly rate from $104 to $66. Next, the annual hours went from 2,080 to 1,820 given vacations, golfing, holidays and general screwing-around. Lastly, less time was spent performing doctor tasks (80% to 75%). In other words, the time spent was less valuable and the amount of time spent was reduced. Double dip!

Please keep in mind too that reasonable compensation includes self-employed health insurance and HSA contributions (and health reimbursement arrangements, and long-term care and disability premiums too). Therefore, if RCReports comes up with $80,000 but your self-employed health insurance including dental and vision is $10,000, then your shareholder salary should be $70,000. This alone saves you $1,500 in unnecessary payroll taxes (we had some tables in a previous chapter showing this arbitrage as well).

Sidebar: Health Reimbursement Arrangements (HRAs), Long-Term Care and Disability should be paid by the business. No, they are not income tax deductions. No, your benefits are not taxable should you receive them. However, these payments buttress your reasonable salary calculations. In simple math, you save 15% of these amounts through the reduction of salary which reduces your Social Security and Medicare taxes. We expand on this in a later section.

We can do a reasonable compensation analysis for you. Yeah, we charge you about $400 but it gives you a defensible salary and some peace of mind. Bargain!

By Jason Watson, CPA
Posted Thursday, November 2, 2023

Many S corporations have multiple shareholders, and several are husband and wife teams. In these cases, we determine a starting point as a collective and then massage from there. Using $60,000 as an example, perhaps one spouse should be paid $40,000 and the other spouse be paid $20,000 commensurate to his and / or her individual worth to the business. In other words, don’t double the salary once you determine your starting point because you have two shareholders. The starting point is for all aggregated shareholders, and from there you can divvy it up, massage it, increase it, etc.

Your spouse should be considered an officer within the corporate governance or documentation. Otherwise, splitting the salary between the two of you results in a lower overall officer compensation since non-officer salaries are placed on Line 8 versus Line 7 of the S Corp tax return (Form 1120S).

Remember, this would only be for materially participating shareholders. You could have your spouse be an inactive investor in your S corporation at 20% and you would remain at 80%. As we’ve mentioned previously, one of the reasonable salary tests is the relationship between salary and shareholder distributions. Therefore, if you own 80% of a business taxed as an S corporation, you are receiving 80% of the distributions. Subsequently, your salary could be possibly reduced (but your salary is still ultimately dependent on you and your value to the business).

Here is a table assuming a 35% jumping off point for salary with a column at 100% ownership and 80% ownership to further explain-

To reiterate, the $100,000 line above would $100,000 x 80% x 35% = $28,000 resulting in a payroll tax savings of $1,071. Note that is a savings of payroll taxes, and not income taxes since the 80% and the 20% would flow presumably onto a jointly filed individual tax return.