The S-Corp Grind, Operational Hassles
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You’re probably thinking that running an S-Corp adds all kinds of burdens. There are very few operational hassles with an S-Corp as compared to other entities. All the things you do now to maintain your financial records remain the same. And the things you do in terms of corporate governance such as meetings, minutes and voting, also remain the same.
The two other requirements are paying a reasonable salary through payroll and preparing a corporate tax return. And if you use the Watson CPA Group (and you should), then this hassle is ours not yours. Well, not entirely true- we are attached at the hip if we prepare your tax returns, and while we can be demanding for a comprehensive tax return the hassle is mostly ours.
First things first. There are certain businesses such as insurance agents, investment advisors, realtors and consultants that might be precluded from receiving income and the subsequent 1099 tax form in the business name. In other words, your social security number is being used to report the income to the IRS. Not to worry. We nominate this income to the S Corporation and all is good with the IRS.
Specifically, the 1099-MISC associated your social security number (SSN) is entered on your personal tax return. A reversing entry is made in the name of your S Corporation’s employer identification number (EIN). Net zero on your personal tax return. The S Corp assumes the income. And pushes it back down to you in the form a K-1 and W-2 after expenses, etc.
1099’s SSN to S Corp’s EIN to K-1’s SSN and W-2’s SSN. Full circle with S Corporation sanitizing of the income.
Reasonable Salary Determination
There are several factors to consider when coming up with a reasonable salary. The IRS through Fact Sheet 2008-25 released the following laundry list (last update was in 2008 when Flo Rida was singing Low.. come on.. you know.. apple bottom jeans, boots with the fur, the whole club was looking at her.. sorry, we digress)-
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history (IRS nomenclature, really this should be shareholder distributions)
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Clear as mud. This is the best the IRS can come up with? What is even more frustrating or perhaps embarrassing is that this list was the final draft after probably several meetings and rough drafts. Having said that, this is how our tax system operates in many ways- leave lots of wiggle room for interpretation so the law and the standard can evolve.
The above list tends to be more applicable to S-Corps with multiple shareholders and / or multiple employees where hours, responsibilities, and levels of expertise might vary.
For a one-person show a good starting point is 50% of your net profit. So, if you net profited $50,000, a $25,000 salary would be reasonable. Again this is a jumping off point. You must be able to justify the number, and this number could increase or decrease. The tax court has also weighed in with their own list. Keep reading.
Here are some other issues the Tax Court has used to help calculate a reasonable salary-
- The character and financial condition of the corporation
- The corporation’s compensation policy for all employees and the shareholder’s salary history
- Whether a hypothetical, independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation
- The size and complexity of the business
- A comparison of salaries paid to sales and net income
- General economic conditions
- Salaries versus distributions and retain earnings
No single factor controls. It really is a preponderance of the evidence as civil courts like to say. Dividends in the form of K-1 income cannot be enumeration for services provided by the shareholder-employee.
Truth be told there is some philosophical issues with the reasonable salary element where your labor is the only material income-producing factor for the business. Some would argue that all the S Corp’s income should then be considered wages and subjected to Social Security and Medicare taxes, because if you died the company would die. And do we see this “loophole” being re-defined and shrinking over the next several years? Yes. But at the same time, we say let it ride until we can’t. The IRS and Congress move at glacial speeds- let’s worry about next time, next time.
Tax Court Responses
Interestingly, the IRS is cracking down on S-Corp owners who do not pay any salary. In a recent tax court case (TC Summary Opinion 2013-62) the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S-Corp’s net income of $231,454. Not bad. He still took home over $130,000 in K-1 income, and avoided self-employment taxes on that portion of his income. Also, the Bureau of Labor Statistics can be used to determine what others in your profession and zip code should earn as a salary. Spoiler alert- the BLS data typically benefits you with a low yet reasonable salary, and the information is based on government data. A win-win scenario.
Another tax court case involved a guy named Watson, no relation to the Watson CPA Group. In this case, Watson was an accountant in a firm he owned. He drew a salary of $24,000 even though the firm grossed nearly $3 million in revenue. Watson was a CPA with advanced degrees. The 8th Circuit Court ruled that a reasonable person would consider the dividends paid to Watson to be “remuneration for services performed” as opposed to a return on investment. W-2 versus K-1. As a result, Watson’s dividends were reclassified as wages and the firm was assessed huge employment taxes plus penalties and interest.
Bureau of Labor Statistics
So the Tax Court and the IRS will attempt to determine a reasonable salary based on your peers and colleagues. Our previous real estate agent benefited from this type of valuation. But what if the opposite was true. So, instead of earning $231,454 and only paying out $100,755 in salary, what if you earned $110,000. Would you have to pay out $100,755 in salary just because you are a real estate agent in an area where other agents earn $100,755?
The answer is No. There are several factors that mitigate this. Perhaps you work part time. Perhaps you simply are not as good as your peers. Perhaps you focus on a different type of customer.
And, the Tax Court will still compare salaries to net income for proportional perspective, not an absolute perspective.
Also keep in mind, if you have employees working for the company you should pay yourself at least the amount you pay the highest-paid employee. In other words, your admin should make less than you in salary unless he or she does a better job running your business than you do.
Salary First, Distributions and Loans Second
Shareholders must be paid a salary before any shareholder distributions are paid out or loans are advanced to shareholders. If the business cannot afford to pay salaries, it is not necessarily required to do so. There is some gray area involving large depreciation expenses and other non-cash reductions in business income. So, if you have a pile of cash but experience a loss due to large depreciation, for example, you might still be required to pay salaries. If you believe your company won’t be profitable, then we suggest deferring the S-Corp election to another tax year.
There are some other tricks of the trade that will be explained later (accountable plans, salary shifting, etc.).
As far as actually writing paychecks, the Watson CPA Group offers accounting and payroll services. Here is the typical pricing for some services-
|Corporate Tax Return Only||$450 to $600||depending on the quality of your books|
|Quarterly Accounting||$200 to $400||per quarter|
|Quarterly Payroll||$200||per quarter, 1-5 employees (owners), includes consult|
|Monthly Accounting||$175 to $300||per month|
|Monthly Payroll||$120||per month, 1-5 employees, bi-weekly, unlimited HR help|
These are typical prices. If we perform all three services (tax return, accounting and payroll) additional discounts are usually provided. For example, most one or two-person companies with a single checking account and a single credit card can expect to spend right around $2,100 per year or $175 per month. $800 for payroll, $800 for accounting, and $500 for the S Corporation tax return.
A lot of small businesses don’t need accounting. In these situations your costs will be about $1,300 to $1,400 per year.
What about personal tax return? For small business owners, our fee is usually between $250 and $350.
You can always find someone to do it for less- we know that. At the same time, we have a vested interest in your success and provide sound tax and business consultation as a part of our service.
These general fees will cover most situations. However, depending on the number of transactions, accounts and employees, these fees might have to be adjusted to reflect additional complexities. The Watson CPA Group is not out to gouge anyone or do a quick money grab- we want to build relationships by doing things right for a reasonable fee.
Back to the topic at hand, payroll. Unless you have other employees, we suggest shareholders to pay a reasonable salary to themselves quarterly, for a total of four pay checks per year. Don’t freak out- you don’t have to wait for us to run payroll for you to get paid. You take money out of till anytime.. daily, weekly, monthly, etc. to put cash in your personal bank account. More on that in a bit.
The quarterly payroll run will coincide with your estimated tax payments on your K-1 income. Remember, you can write checks directly to yourself as often as necessary throughout the quarter. These are considered shareholder distributions. More about payroll amounts, shareholder distributions and re-classification later in this book, including how to handle quarterly payments.
Corporate Tax Return
An S-Corp must file a corporate tax return by March 15 and there are additional financial reporting requirements. However, if you use the Watson CPA Group to prepare your tax returns, we’ll make it seamless and pain free. Ok, taxes and pain free don’t really go together, but you get the idea.
S-Corps file a Form 1120S and this in turn creates K-1s for all the shareholders. Unlike many other tax professionals, we always create a balance sheet and we always reconcile paid-in-capital accounts (shareholder bases). This can be challenging for us, but we feel it is important for you, the client, and for long-term reporting accuracy.
For example, if you invested $10,000 into your company, but your company lost $20,000, your K-1 will show a $20,000 loss but you are only allowed to deduct your basis which is $10,000. Without tracking this information, you could be incorrectly deducting losses. More importantly, without paid-in-capital and shareholder basis information, there is no way to determine the gain on your future business sale. Just like stock sales, when you sell your company for a zillion dollars the IRS will consider all that to be capital gain unless you can prove otherwise.
Business succession, exit strategies, asset sales, Buy-Sell Agreements, etc. are topics rarely considered by most small business owners. And that is OK. But as accountants and business consultants, it is our job to keep you out of future trouble by putting things on the right track today.
And creating a balance sheet is just good accounting practice, and it contributes to the overall tracking of your company’s worth. Lenders and investors will also want to see this information if you need leveraged financial assistance for company growth.
If the Watson CPA Group prepares your corporate tax return, we will ensure a comprehensive tax return to include all of this information. Not all tax accountants or firms can say this. Be informed. Visit our fee structure for more information-
The Epilogue also has a summary of our fee structure.
Taxpayer’s Comprehensive Guide to LLCs and S Corps
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