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S Corporation Owners, is Your Salary too Low?

  • Posted by Michael Beauchemin on Thu, Mar 01, 2012 @ 11:34 AM

    Are you an owner of an S Corporation?  If so, you may want to do a salary checkup and make sure your salary is reasonable and customary.  Ealier this year the Eighth Circuit Court upheld a lower court’s decision regarding the salary of the owner of an S Corporation.   

    payroll-tax-guide-2012-cta1

    In 2002 and 2003 the owner of the S Corporation paid himself a salary of $24,000 while taking distributions of $230,651 and $175,470 respectively. Based on an expert witness hired by the IRS, the IRS argued that the owner’s salary was unreasonably low and that a reasonable salary for this owner was $91,044.   

    The benefit to an owner of an S corporation, for taking compensation as distributions rather than as W2 wages, is that they save themselves the Federal Insurance Contributions Act (FICA) taxes commonly known as Social Security and Medicare taxes. 

    The IRS argued the owner was underpaying himself by $67,044.  Accordingly, based on the IRS’ argument, these are wages that should have been subject to Social Security Taxes and Medicare Taxes. 

    Back in 2002 and 2003 the Social Security and Medicare taxes for an owner was set at a rate of 15.3% (7.65% owed as the employee and 7.65% owed as the employer).  The total tax on the additional $67,044 in wages equals $10,258 per year ($67,044 multiplied by 15.3%).  For the two years in question, the total additional Social Security & Medicare tax would have been $16,626. 

    The Eighth Court affirmed the lower courts decision and based on the owners work experience and knowledge, the $24,000 salary was unreasonably low.  

    Additional information about the court case and the IRS argument can be found here at the Journal of Accountancy’s web site in an article published by Sally Schreiber.

    It is important for an S Corporation owner to seek advice from a professional CPA to help him or her determine a reasonable salary for the purpose of payroll wages.  If the IRS believes your W2 wages are too low you may be in the unenviable position of trying to defend it to the IRS.  If you can’t make a legal argument or justify your wages before the IRS (or courts) and the IRS determines they are too low, you will owe additional FICA taxes plus penalties and interest.