Subchapter S corporation reduce substantially the payroll, or employment taxes, that business owners pay when shareholder salaries get set to a modest level.
But you need to be reasonable. The IRS watches S corporation shareholder-employee salaries very, very closely. Fortunately, you can use several tricks to effectively push down the salary you need to pay yourself.
S Corporation Salary Tip #1: Correctly Account for Shareholder Health Insurance
One easy way to effectively set the salary of shareholder-employee to a low level is to correctly account for self-employed health insurance.
Here’s the deal: In an S Corporation amounts paid to shareholders for health insurance count as salary. However, amounts paid as health insurance don’t get subjected to Social Security or Medicare taxes.
Accordingly, if you do the accounting right for health insurance provided to shareholder-employees, you in effect boost the reported salary amounts but without increasing payroll costs. This means you save payroll taxes.
Example: If an S corporation pays a shareholder-employee $40,000 in wages and provides $10,000 of health insurance, the total wages reported should be $50,000. Note, however, that only $40,000 of this money will be subjected to payroll taxes.
S Corporation salary Tip #2: Consider a Simplified Employee Pension Plan
Another effective way to support a lower salary for a shareholder-employee in an S Corporation is to use a pension plan option based on employer contributions rather than on employee contributions. This works because employer contributions end up being deductions both for income taxes and payroll taxes.
Something like a Simplified Employee Pension plan, or SEP-IRA plan, does this wonderfully well, for example. If a shareholder-employee makes $40,000 a year, the maximum Simplified Employee Pension plan contribution equals 25%, or $10,000, a year.
However, the $10,000 though counting as compensation is not subject to Social Security or Medicare tax. (By the way, the pension contribution also isn’t subject to income taxes.)
S Corporation Salary Tip #3: Be Conservative But Not Greedy
One final tip is in order: You can be conservative about setting shareholder-employee salaries. The recent tax court case of CPA David Watson essentially confirms the approach where an S Corporation sets a low-end-of-the-range salary. (In the Watson tax court case, the court accepted roughly a $90,000 salary for a CPA making nearly $250,000 a year in his accounting practice.)
Don’t, however, get too greedy. The S corporation tax return makes it very easy for the Internal Revenue Service to spot outrageously low salary levels. Remember the old adage: pigs get fat but hogs get slaughtered.
Recommended Books on S Corporation
- How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners
- Taxation of S Corporations in a Nutshell (In a Nutshell (West Publishing))
- Practical Guide to S Corporations (6th Edition)
- LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- S Corporation ESOPs, 3rd Ed.