There are presently at least 12,000 New Hampshire businesses whose owners are subject to federal income taxation under Internal Revenue Code Subchapter S. As you will know if you are one of these owners, your LLC or business corporation has to make a proper election in order to be an “S corporation.” But if it does so, your share of its income will not be taxable to your company under the Internal Revenue Code, but rather, only to you yourself. In other words, you will owe only a single level of federal tax on this income.
Furthermore, the salary you pay yourself if you are both a shareholder and an employee of your company will be subject not only to federal income tax in your hands but also to a Social Security Tax call FICA. FICA taxes apply at a rate of 15.3% on the first $137,700 and 2.9% on any excess. FICA taxes are split equally between an S corporation’s employees and the employees’ company. But of course if you own the company, you will effectively have to pay both your own FICA share and that of your company.
However, the net income of your company — i.e., its gross income less all of its expenses, including your own salary — will not be subject to FICA. For many S corporation shareholders who are also employees of their company, this creates a major temptation — namely, to pay themselves the lowest possible salary so as to maximize their share of their company’s net income. In addition, in general, the higher your net business income, the greater will be your section 199A deduction — which can amount to 20% of that net income for the relevant taxable year.
However, a major IRS rule applicable to S corporation shareholder-employees is the IRS “reasonable compensation” rule — namely, a rule that shareholder-employees must pay themselves a “reasonable” salary. If you violate this rule, you may face an exceedingly unpleasant audit.
What salary, then, must you pay yourself to avoid such an audit? The issue of what constitutes reasonable compensation under the above IRS rule is perhaps the murkiest issue in the entire several thousand pages of the Internal Revenue Code and its regulations. Below are a few guidelines that may be helpful to you and your accountant in answering this question. But to make things concrete, let’s assume in this column that you are your company’s only shareholder; that in 2020, your company will gross $200,000; and that its net income except for your salary will be $100,000.
If you are the only employee of your company and your company’s income is attributable only to your work, then you should very probably pay yourself a salary of $100,000. If, however, you have any non-shareholder employees or valuable company assets (including both physical assets, intellectual property and goodwill not directly attributable to you), you’ve got a great deal of flexibility under the IRS reasonable compensation rule. Here are some guidelines in exercising that flexibility:
— The most important IRS reasonable compensation guidelines are in an IRS document called “Reasonable Shareholder Salary.” Whatever other guidelines you use in answering the above question, these IRS guidelines must be your starting point.
— You’ll find extensive and excellent guidelines for determining your reasonable compensation in an online article by an accounting firm called WCG The article is entitled “Reasonable Shareholder Salary.”
— As the above article makes clear, the reason it is so difficult to determine reasonable compensation with confidence is that every S corporation has at least a few unique features, and the same may be said of every S corporation shareholder-employee. For example, some S corporation shareholder-employees may have unique personal gifts that are indispensable to their company.
— If you pay yourself a very low salary—say, $25,000—you may well get audited.
— However, the less the IRS stands to gain in FICA taxes, interest and penalties from a successful reasonable compensation audit of you, the less likely the audit.
— In general, if you pay yourself the same compensation you’d pay a non-shareholder-employee to do the work you do, you’ll probably be safe from an audit. However, determining the amount of this third-party compensation may be difficult.
— If, before the beginning of the relevant taxable year, you (with the help of your accountant if you have one), you prepare a written document stating what you believe to be reasonable compensation from your company to you and the reasons for that determination, this document may greatly help you if you do get audited.
— If you obtain a written reasonable compensation determination from an independent organization that has a good reputation in making these determinations, this may entirely protect you from an audit.
To conclude, I’ll go out on a limb: If your company has one or more non-shareholder employees or valuable business assets, I suspect you won’t face an IRS reasonable compensation audit if you pay yourself at least $55,000. But this is just a guess.
John Cunningham is a Concord, NH lawyer of counsel to McLane Middleton, P.A. His practice is focused on LLC formations, general business and tax law, advising clients under IRC section 199A, and estate planning. His telephone number is (603) 856-7172, his e-mail address is [email protected], and the link to his website is www.llc199A.com.