Determining a reasonable salary is the hardest part of running an S corporation. What the heck do I pay myself? Before we get into that, let’s discuss why shareholder salary needs to be just above bar napkin quality and just below NASA precision.
Scattered throughout this book we’ve stressed that the only tax savings an S Corp provides is the reduction of self-employment taxes, and in the case of shareholder wages we are talking about Social Security and Medicare taxes (payroll taxes). When your business pays you $10,000 in shareholder wages, 7.65% is withheld from your pay check for the employee’s portion of payroll taxes. This is broken down into 6.2% Social Security tax and 1.45% Medicare tax. The business also must pay 7.65% for a combined percentage of 15.3%. Since the business deducts its portion of payroll taxes, the effective tax rate is 14.1%.
Therefore, a $10,000 shareholder salary costs you $1,410 in additional taxes beyond income taxes. Said in a different way, if you pay yourself $50,000 when $40,000 could have been a reasonable shareholder salary, you just wasted $1,410. Even a $5,000 delta equates to $705.
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 shareholder wages and subjected to Social Security and Medicare taxes, since if you died the business would die. 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 use it. The IRS and Congress move at glacial speeds- let’s worry about next time, next time.
Conversely, there might be times where your business would continue without you. When the Watson CPA Group does business valuations, especially in divorce proceedings, we assign a value to goodwill. We do this by taking a number called seller’s discretionary cash flow (SDCF) and we subtract the cash flow that is derived from tangible assets (cash, equipment, etc.). This leaves us with a theoretical number that is considered goodwill which can be used as a proxy to determine your “value” to the business.
We further tease out personal goodwill and enterprise goodwill since in some jurisdictions personal goodwill is not marital property. This might seem like an odd tangent, but a similar argument can be made for a business that does not rely on you. One great example is a financial advisor that has a small team supporting him or her- typically the fee income continues well into the future without the direct involvement of the advisor (enterprise goodwill). In this situation, an argument for a smaller salary could be warranted since enterprise goodwill exceeds personal goodwill.
Of course, this is all theoretical and is open to debate, but you get the idea.
Not to go too far into the weeds, but when performing business valuations we also consider investor value. What rate of return would an investor need to earn after paying you a reasonable salary? In other words, what would someone be willing to pay you to continue running the business after they acquired it from you?
Naturally, a lower salary to you results in a higher rate of return for the investor. We also look at the earnings generated from capital investments such as machinery and other non-owner employees versus shareholder labor. We digress…
In this chapter, we will review-
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition