Under today’s current tax laws, most of our clients have elected to become S-Corporations for federal income tax purposes. S-Corporations have many advantages over conventional Corporations and Partnerships, which is why they have become so popular. One of the greatest advantages is the ability to make and control distributions of after-tax profits at any point, for any reason. The only caveat that to this is that the owner is taking a “fair and reasonable” salary from the company if they are working in the business.
This leads us to one question that I get asked all the time; “How much should the owner’s salary be?” When answering this questions we have to take 3 different considerations into account: future Social Security impact, payroll taxes and IRS guidelines.
Social Security and Medicare taxes are calculated at 15.3% of the wage base. The wage base is the lesser of the actual salary or the annual max. (For 2018, the max base is $128,400. Once your salary exceeds that base, no additional SS tax is collected, MC does continue.) Social Security benefits are calculated using an average of your highest wage base 35 years of employment. There are adjustments for time, but simply put, if you average $100,000/year for 35 years, your Social Security base will be $100,000. The current max Social Security benefit is almost $2,800/month. However, if your average base is $60,000/year, your estimated monthly Social Security benefit will be roughly $2,000/month.
As you can see, there is an increase in the future Social Security benefits by maxing out your SS contributions. However, there is a law of diminishing returns – as the dollars contributed go up, the future benefit goes up, but by less and less. If you pay yourself $125,000 this year, you will pay almost $19,000 in payroll taxes for Social Security and Medicare (15.3% of wages). If you pay yourself $60,000/year you will pay in about $9,000/year in payroll taxes. So in a situation where a company had $125,000 a profit and chose to pay it all out in wages to the shareholder, they would spend roughly $10,000 more in taxes than if they decided to lower the wages to $60,000. If the company decided to pay no wages to officers, they would not pay any payroll tax for Social Security.
The last consideration that needs to be factored in is the “fair and reasonable” test that the IRS uses for audits of S-Corporations. The IRS states that “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” In essence, you can make and distribute as much money as you want, as long as the officers is being fairly compensated for his job. The IRS does not give official guidance on how to calculate a “fair and reasonable” salary, but a good rule of thumb is how much you would have to pay to replace yourself. Simply put, “What would you pay someone else to do the same job?” Would you have to increase another employee’s salary? Would you have to hire a person? There are tons of resources out there to get salary and pay scales to give you a good base for your decision.
As you can see there are many factors that come into play when deciding an officer’s salary. Too high and you are throwing money away for benefits you will never receive, too low and you could be in the crosshairs for the IRS and severely limit your future Social Security benefits.