■ S corporation Charades: So your CPA recommended an S corp. instead of an LLC to save payroll taxes. Slick move dude. Like the IRS wouldn’t suspect that. Right? Take a peek at “Report to the Committee on Finance, U.S. Senate TAX GAP Actions Needed to Address Noncompliance with S Corporation Tax Rules.” http://www.gao.gov/new.items/d10195.pdf. Check out this pearl of an excerpt: “Even though a majority of S corporations used paid preparers, 71 percent of those that did were noncompliant.” Got your attention? Now try this one out for size: “Some S corporations also failed to pay adequate wages to shareholders for their labor for the corporation, which led to underpaying employment taxes.”
So what’s the real deal? Determining how much can be distributed from a business without being subject to payroll taxes should be based on an intelligent analysis of the facts. One approach might be to independently determine a reasonable return on the capital in the business and separately to determine a reasonable compensation for the services rendered to the business (considering industry data, comparable prices for others providing similar services, and adjusting for the differences of your particular business). Subtract these from profits. If there’s a difference evaluate a reasonable method to allocate that difference against your estimates for compensation and/or return on capital. You could just take the easy, smart but more costly approach, and hire an appraiser to document the figures. There is a wealth of tax law that can provide guidance as to the factors to consider in any analysis. Reasonable compensation is a permitted deduction under Code Section 162(a)(1). The determination should be based on the facts and circumstances of each case. Treas. Reg. 1.162-7(b)(3). Factors might include: ◙ The employee’s role and contribution. ◙ How the employee’s compensation compares with similar employees of other businesses. ◙ The nature and financial condition of the corporation. ◙ Dividend payment history of the corporation. ◙ Compensation to other employees relative to their work load and responsibility and the internal consistency of the compensation for the employee in question. Mayson Mfg. Co. v. Commr., 38 AFTR 1028 (178 F.2d 115), 11/17/1949.
The one thing that you really shouldn’t do is simply set up your business as an S corporation and assume, as your CPA may have told you, that you can just treat some modest amount as wages, and take the bulk out as an S corporation distribution not subject to payroll taxes. Superficial assumptions might lead to not so superficial penalties!
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