Brian’s Tax Musings

I have many clients who have S Corporations and are always asking how much profits should be paid in salary and how much can be taken as income not subject to payroll taxes.

There is not clearcut answer, but the Bradford Tax Letter has this situation and a little clearing up of the problem:

“A standard S corporation tax strategy is to pay a low salary to save on payroll taxes.Earlier this year, we published an article titled “Reasonably Low Salary for S Corporation Owner”that addresses what you need in order to justify a low salary and states that the zero salary is out. David E. Watson, CPA, a tax partner in the Iowa accounting and wealth management firm ofLarson, Watson, Bartling, and Juffer (LWBJ) suffered a salary-too-low problem.  He and the other partners in the firm operated as individual S corporations with a 25 percent interest each. The firm paid its profits to the four individual S corporations of the partners.  In 2003, Mr. Watson’s S corporation paid him $24,000 in salary and $222,000 in dividend distributions. The IRS disagreed. It wanted $199,000 in salary and $47,000 in distributions.  Mr. Watson took the IRS to court, asking for summary judgment.  During the court’s fact finding, the IRS’s expert witness, Igor Ostrovsky, several times amended his opinion of reasonable salary. As the court finalized its inquiries, the IRS’s reasonable salary demand had dropped to $91,000, leaving $155,000 as dividend distributions.  The court denied Mr. Watson’s summary judgment; therefore, the IRS technically won this case, but we give kudos to Mr. Watson for getting that salary down from the original IRS demand of $199,000 to $91,000. That $108,000 drop saved Mr. Watson serious cash.

Planning note. You can see from this case that pegging the salary at the appropriate amount is more art than science. In this case, the salary started at $24,000 (too low), then it rose to $199,000 (too high) before settling at $91,000.