How S Corporation Payroll Tax Works

With regard to S Corporation payroll tax, there’s a bit of flexibility when it comes to filing taxes and giving yourself a salary. However, it’s a slippery slope, because S Corporation owners need to be careful in making sure their salary is deemed “reasonable compensation” for the work they’re doing.

S Corporation owners are technically self-employed, which means S Corporation payroll tax includes both the employee and employer sides of payroll taxes. Therefore, when an S Corporation owner files his taxes, he pays 15.3% tax on his salary, but also accounts for the rest of the company’s income on his return, which remains untaxed. Oftentimes, S Corporation owners will try to reduce the amount they’re required to pay in payroll taxes by reducing their salaries, thereby reducing the amount that’s taxed.

In our previous post, we used Alison as an example, who owns an S Corporation that made $700,000 in profits last year, and gives herself a salary of $300,000. She reports $1,000,000 on her personal tax return, but only pays income tax on $300,000 of it. Let’s compare her to someone who gives himself a reduced salary:

Example 2: Jonathan owns a real estate company that is structured as an S Corporation. His company also reports an annual income of $1,000,000, but he only considers $100,000 of it to be his salary, and the remaining $900,000 is considered profits from the business. By classifying a much lower salary, Jonathan is only responsible for paying $15,300 in S Corporation payroll tax, and is exempt from having to pay the Medicare surtax, because he doesn’t make more than $200,000/year. Jonathan ultimately winds up paying $31,500 LESS in income taxes than Alison does, despite their companies bringing in the exact same amount of money.

Though it sounds like Jonathan’s approach is unquestionably a better choice, it’s not so clear-cut; the IRS could very easily question as S Corporation owner’s salary if it’s suspiciously low. For this reason, it’s important for S Corporation owners to provide proof of the rationale behind their salary decisions. This can be done in several ways.

S Corporation Payroll Tax: How to Defend Your Salary

Use your corporate minutes to spell out your salary level. If you can find statistics that apply, use going industry rates for other executives at similar firms to show that your level of compensation is up to par with theirs.

There are other ways to use your corporate minutes to explain your salary level. For example, if the economy is down or business is slow, you can report that you’ve reduced your salary in order to ensure there is sufficient working capital for the company.

If the company is only a few years old, you can say that you’re keeping fixed costs low to allow the company to grow, but that you expect your salary to increase as the company’s revenue increases.

Alternatively, if you’re getting ready to retire, you can report that as you transition out, you’re putting more responsibilities into the hands of valued employees who will take the reins when you stop working, so you’ve reduced your salary as a reflection of your decreased workload.

If you have more questions about defending your salary to the IRS if you’re the owner of an S Corporation, call the tax professionals at DeFreitas and Minsky LLP today at (516) 746-6322!

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