Officer Compensation: Actively Managing Your Payroll Taxes
Updated: Jan 12, 2021
For those operating their practice under a corporate structure, there are extra considerations surrounding how owners are paid. Many S-corp owners pay themselves excessively via wages, paying an extra up to 15% in payroll taxes. We’ll discuss some guiding factors surrounding proper compensation.
Payroll Tax Evasion
While the primary purpose of the corporate entity is liability protection, many have seen the primary motivation for incorporating as tax reduction.
Sole proprietors, who operate their business without the corporate entity, can pay themselves with cash draws from the business whenever they please. The catch is that every dollar earned by the sole proprietorship is subject to self-employment taxes, up to roughly 15% in aggregate for Social Security & Medicare. It’s slightly more complex in that 12.4% is collected for Social Security up to $127,200, and 2.9% is always collected for Medicare.
Years ago, practitioners concocted a way to shield income from self-employment taxes by diverting its source to within an S-corp, whose earnings aren’t subject to self-employment taxes. However, numerous Tax Court cases uncovered the tax evasion intent and upheld that the owner of an S-corp must be considered both an officer and an employee. Unfortunately, the payroll taxes to which employees are subject are essentially equivalent to self-employment taxes. This leaves the primary corporate function of liability protection in place, but on the surface seems to provide no tax advantage.
The IRS increased enforcement to ensure that S-corp owners paid themselves as employees. Enter the wiseguy who decided to test the limits. Consider a practice that nets $300,000 annually and pays the sole owner a $10,000 salary. The remaining $290,000 is taken as a corporate dividend, equivalent in nature to the cash draw in the sole proprietorship mentioned above. The resulting “savings” in payroll taxes is roughly $23,000, and the Social Security Administration in particular had something to say about it. As a result, Tax Courts not only held that S-corp owners/officers must be employees, but that they must receive reasonable compensation. So would “reasonable” mean that the owner should pay herself the full $300,000 as wages? Not necessary.
Employee And Investor
Beginning ownership in an S-corp initiates two distinct roles. Primarily, you’re the operator of your practice, responsible for likely much of the production of revenue. However, you’re also an investor. You purchased stock in your corporation in a similar manner to having purchased shares of Apple or Microsoft. Therefore, it follows that you should be compensated for each role appropriately.
The operator role should be paid wages that reasonably correlate with effort as an employee, and the investor role should receive non-wage payments (“dividends”) that correspond to a return on investment.
Determining What Is Reasonable
One might assume that the sole owner of an S-corp would be considered to be responsible for producing 100% of the business’ revenue. But what if there’s an associate? And what about the revenue produced by hygiene?
Additionally, there are multiple other factors to consider. How does the owner’s salary compare to both revenue and net income? Consider an S-corp practice with $1.5 million in revenue. What should the sole owner pay himself in wages? If that revenue resulted in $500,000 of net income (before officer wages), a much higher salary would be required than if the business netted just $100,000. The owner who pays herself $250,000 instead of the more appropriate $200,000, for example, is unnecessarily giving the government an additional $1,450 each year!
A shareholder whose investment nets $500,000 would expect more cash dividends as return on their investment. As such, it follows that, relative to the lower net income scenario, a larger percentage of earnings would be distributed to the shareholder as cash dividends.
It’s all too common for owners to maintain static salaries that have no correlation to current year’s revenue and income, and/or ignore how the responsibility for revenue production is distributed across the practice. New owners consistently overpay themselves, especially in initial years of lower earnings.
When you understand the rules, it’s easy to determine a reasonable owner salary after the year has ended. And while it’s possible for an owner to pay oneself in a single, huge paycheck each December, doing so is usually impractical. As a result, there’s a need to continuously manage and project taxable income so as to ensure owners are paid enough but without over-compensating themselves (and thereby the government via payroll taxes). Owners must also ensure that wages are sufficient to fund any desired profit sharing retirement accounts.
If your books stay updated year-round, you’ll be best positioned to structure owner salary as dynamically representative of current financial performance.
S-corporation owners are considered both officers and employees, and must pay themselves a reasonable salary with associated payroll taxes. Determining what is reasonable requires having an ear to the ground during the year so as to project where revenue and income will result. Additionally, the split between wages and shareholder dividends is determined by examining many factors including who produces revenue. Ensuring that wages are actively managed and reflective of current financial performance is critical to paying no more than your fair share of taxes.
Dave Sholer, CPA, MBA works exclusively with dentists in California.