There are currently at least 12,000 businesses in New Hampshire that are owned by federal income tax under Section S of the Internal Revenue Code. As you know, if you are one of these owners, your LLC or business must make proper choices in order to do so being an “S Company”. In this case, your share of the Internal Revenue Code income is not taxable for your business, but for yourself. In other words, you only owe a single federal tax on that income.
Additionally, if you are both a shareholder and employee of your company, the salary you pay yourself is subject not only to federal income tax in your hands, but also to a FICA social security tax appeal. FICA taxes are 15.3% on the first $ 137,700 and 2.9% on any excess. The FICA taxes are divided equally between the employees of an S company and the company of the employees. But of course if you own the company you will have to pay both your own and your company’s share of FICA.
However, your company’s net income – that is, gross income minus all expenses, including your own salary – is not subject to FICA. For many S Corporation shareholders who also work for their company, this is a great temptation to pay themselves the lowest possible salary in order to maximize their share of their company’s net income. In general, the higher your net business income, the higher your Section 199A allowance, which can be 20% of that net income for the relevant tax year.
However, one important IRS rule that applies to S Corporation shareholder employees is the IRS “fair compensation” rule – namely, a rule that requires shareholders to pay themselves a “fair” salary. Breaking this rule can lead to an extremely uncomfortable exam.
What salary do you have to pay yourself to avoid such a test? The question of what constitutes fair compensation under the above IRS rule is possibly the worst question in the entire several thousand pages of the Internal Revenue Code and its regulations. Below are some guidelines that can help you and your accountant answer this question. To be specific, let’s assume in this column that you are the only shareholder in your company. that your company will gross $ 200,000 in 2020; and that his net income, excluding your salary, is $ 100,000.
If you are the sole employee of your company and your company’s income comes solely from your work, you should most likely pay yourself a salary of $ 100,000. However, if you have employees without shareholders or valuable corporate assets (including physical assets, intellectual property, and goodwill not directly attributable to you), you have a great deal of flexibility under the IRS fair compensation rule. Here are some guidelines for exercising this flexibility:
– The key IRS guidelines for fair compensation are contained in an IRS document entitled “Shareholder Appropriate Salary”. Regardless of the other guidelines you use to answer the above question, these IRS guidelines must be your starting point.
– See an online article from an accounting firm called WCG for detailed and excellent guidelines for determining your fair compensation. The article is entitled “Fair Shareholder Salary”.
– As can be seen from the above article, it is so difficult to determine adequate remuneration with confidence because every S company has at least some unique characteristics, and so does every S company shareholder employee. For example, some S Corporation shareholder employees may have unique personal gifts that are essential to their business.
– If you are paying yourself a very low salary – say, $ 25,000 – you may be screened.
However, the less the IRS gains in FICA taxes, interest, and penalties from a successful fair compensation check, the less likely it is to be checked.
– If you are paying yourself the same compensation that you would pay a non-shareholder employee for the work you did, you are likely to be safe from an audit. However, it can be difficult for a third party to determine the amount of this compensation.
– If, before the start of the tax year in question (with the help of your accountant, if you have one), you prepare a written document stating what you think is fair compensation for your company and the reasons for that determination, this document will suit you a lot help when tested.
– Obtaining a written reasonable compensation statement from an independent organization that has a good reputation on these determinations can protect you completely from an audit.
In conclusion, if your company has one or more employees with no shareholders or valuable business assets, then paying yourself at least $ 55,000 will likely not get you an adequate IRS compensation review. However, this is only a guess.
John Cunningham is a lawyer from McLord Middleton, PA, Concord, NH. His practice focuses on LLC formation, general business and tax law, advising clients under IRC Section 199A, and estate planning. His phone number is (603) 856-7172, his email address is lawjmc@comcast.net, and the link to his website is www.llc199A.com.