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Tips for Setting Low S Corporation Shareholder Salaries

The big tax savings in a small S corporation usually come from setting the salaries of shareholder-employees to something that's low yet reasonable. Lowering a shareholder-employee salary by, for example, $10,000 often saves about $1,500 in payroll taxes annually.

You need to be cautious about setting low S corporation shareholder salaries, however. Set a salary unreasonably low and the IRS can reclassify payments made to shareholders as wages. That reclassification allows the IRS to clawback tax savings and assess penalties and interest.

Fortunately, you can take employ several techniques to reasonably lower S corporation shareholder-employee wages, including the tips that follow:

S Corp Salary Tip #1: Use Government Data for Backup

The big requirement concerning S corporation shareholder salaries is that the compensation be reasonable. Reasonableness, in some ways, is in the "eye of beholder."

But a good starting point concerning reasonableness is the Bureau of Labor Statistics web site at www.bls.gov. The bls.gov site provides a wealth of conservative data about what different jobs really pay.

S Corp Salary Tip #2: Learn About Any Local Safe Harbors

Another tip related to setting a low shareholder salary: Talk with a knowledgeable local tax practitioner about the possibility that there's an unofficial safe harbor.

Now let me be clear: Publicly, no IRS official will provide a safe harbor amount--a salary level which, if you're over, you're officially safe.

However, numerous tax practitioners (CPAs, attorneys, and enrolled agents) report that in many areas, Internal Revenue Service examiners have an unofficial salary which they'll accept as reasonable. An S corporation which pays its shareholder-employees at least this amount seems to be very unlikely to be challenged or penalized...

S Corp Salary Tip #3: Treat Shareholder Health Insurance Correctly

The S corporation tax return itself makes it really easy to spot when an S corporation pays its shareholders low salaries: The first business deduction on page 1 of the corporate tax return, for example, shows officer compensation!

You should, therefore, verify that you're handling shareholder health insurance correctly. Here's why: Shareholder health insurance gets added to the shareholder-employee compensation amounts. If a shareholder-employee earns, say, $30,000 in wages and in addition receives $10,000 of health insurance, the shareholder-employee's W-2 should show $40,000 of wages.

By the way, the health insurance amount added to the employee's W-2 wages isn't subject to payroll taxes like social security or medicare. Using the previous paragraph's example numbers, the shareholder-employee's W-2 would show the wages subject to social security and medicare taxes as being $30,000. Furthermore, the $10,000 of health insurance is allowed as a deduction on the shareholder's individual tax return.

S Corp Salary Tip #4: Save for Retirement Inside Corporation

Another easy idea related to setting a low yet reasonable S corporation salary: If you're saving money for retirement, you may as well do that saving inside the S corporation. In other words, rather than have the shareholder-employee contribute money into an Individual Retirement Account, the S corporation should probably consider making a pension fund contribution such as for a SEP-IRA. Why? The pension contribution in this case gets treated as an expense on the corporation's tax return.

In effect, this increases by shareholder-employee's wages by as much as 25%. Yet this increase in wages does not increase the payroll taxes. Current tax law doesn't subject employee pension contributions to payroll taxes.

About the Author:

Stephen L. Nelson CPA practices public accounting in Seattle, Washington. Nelson edits the Do-it-yourself S Corporation web site and authored the Setting S Corporation Salaries ebook, available at www.scorporationsexplained.com/settingScorpsalaries.h tm

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