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April 2008
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Finance and Taxes: Owner compensation: Too much or too little
What’s the best way to compensate yourself as a principal in your practice? That’s a difficult question to answer, especially under the watchful eye of the Internal Revenue Service (IRS).
If you leave money in the practice to avoid taxes, the IRS often sees — and penalizes — what it calls “accumulated profits.” But, if you pay yourself too much, the IRS may feel you ignored paying dividends and therefore had a distorted tax bill.
Recently, the IRS has been directing its focus to the compensation of owner-employees of businesses operating as S-corporations.
WHAT IS AN S-CORPORATION?
An S-corporation is an incorporated business, such as a practice, with a limited number of shareholders (75 or fewer) that chooses or elects not to be taxed as a regular C-corporation and meets a number of other requirements imposed by lawmakers.
Shareholders in S-corporations generally include on their personal income tax returns their pro rata share of the S-corporation’s capital gains, ordinary income, tax preference items, and similar items.
In other words, an S-corporation is a pass-through type of business entity, similar to a partnership, which avoids corporate double taxation while providing limited liability for the shareholders in the chiropractic practice.
GETTING MONEY OUT
The tax law labels a distributive share (whether or not actually distributed) of income or loss from any trade or business carried on by a partnership as net earnings from self-employment (NEFSE).
Whether this general rule applies to limited-liability companies (LLCs) remains unclear, although, in theory, the distributive share of an LLC member classified as a general partner is NEFSE and that of an LLC member classified as a limited partner is not.
An S-corporation shareholder, on the other hand, can be an employee of the S-corporation. Any wages paid to a shareholder-employee by the S-corporation are subject to payroll taxes. Similar to self-employment tax, payroll taxes are imposed on employees at the rate of 6.2 percent on the first $97,500 of wages and a rate of 1.45 percent on the entire amount of wages.
FICA is also imposed on the employer.
Self-employment (SE) tax is applied to an individual’s net earnings from NEFSE. The tax is applied at two levels: A rate of 12.4 percent is imposed on the first $97,500 NEFSE for old age, survivors, and disability insurance, and a rate of 2.9 percent is imposed on the entire amount of self-employment income for hospital insurance.
An individual is allowed a deduction equal to 7.65 percent of trade or business income in calculating NEFSE.
Those chiropractic practices operating as S-corporations that pay shareholder-employees no salary obviously achieve significant employment tax savings — especially when compared to a sole proprietorship or partnership.
Thus, it should come as no surprise that many S-corporations have attempted to eliminate or minimize employment tax by making tax-free distributions to shareholder-employees, all the while paying them little or no salary even if the shareholder performs services for the chiropractic practice.
Partners and shareholders of S-corporations are subject to tax on income (other than the entity’s dividends and capital gain) at the rates applicable to ordinary income. Even after their reduction under the new law, however, these rates can range as high as 35 percent.
Before 2003, the net income from a regular corporation’s business, paid out to shareholders as dividends, was taxable as the recipient’s ordinary income. By comparison, under the current tax law, shareholders of regular corporations pay tax on their dividends at 15 percent (or 5 percent for low-income taxpayers).
AN EMPLOYEE:
TO BE OR NOT TO BE?
Our tax rules impose FICA (Social Security) and FUTA (unemployment) taxes on employers for wages paid to their employees. Under those rules, an employee is defined, in part, as any officer of a corporation.
There is, of course, an exception to the “employee” label for any officer
For federal employment tax purposes, the term “wages” is defined as “all remuneration for employment.” The form of payment is immaterial; the only relevant factor is whether the payments were actually received as compensation for employment.
Consequently, an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee whose wages are subject to federal unemployment taxes.
Employment tax cannot be avoided by paying no salary and instead withdrawing salary from an S-corporation in the form of tax-free distributions. The rules, however, require only a “reasonable” salary.
An employer cannot avoid federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income, rather than as wages.
Regardless of how an employer chooses to characterize payments made to its employees, the true analysis, according to the courts, has been whether the payments represent remuneration for services rendered.
The first rule of thumb is that S-corporations should avoid paying no officer compensation in years in which the business shows a profit.
Those chiropractic S-corporation shareholder-employees who get too greedy and attempt to eliminate all employment taxes by paying themselves no salary in the same year a distribution is made are asking for an IRS challenge.
Many tax professionals advise clients to distribute S-corporation earnings using a combination of salary and distributions. A 60/40 or 50/50 salary to distribution ratio is often suggested.
A practice operating as an S-corporation might, for instance, classify payments to shareholder-officers as 60 percent salary and 40 percent distribution.
Since the issue is whether the salary is reasonable for the services performed by the shareholder-employee, a fixed ratio should not be used in every situation.
Remember: IRS auditors are fully aware of the reasonable compensation issue and are equipped with information on what is considered reasonable salary for particular industries and geographical areas.
Also, keep in mind that distributions are not the only item the IRS can reclassify as wages subject to employment tax. The IRS can recharacterize nondividend distributions, such as loans from an S-corporation to a shareholder-employee, as well as a corporation’s payment of a shareholder’s personal expenses.
Despite the IRS’s increased attention to unreasonably low compensation of S-corporation shareholder-employees, the courts have in the past allowed relief from employment tax liability — if two conditions are satisfied:
• The taxpayer did not treat an individual as an employee for any period, and
• All federal tax returns are filed on a basis consistent wth the taxpayer’s treatment of such individuals as not being an employee.
PLANNING DISTRIBUTIONS
The tax laws permit the IRS to recharacterize the entire amount of an S-corporation distribution as wages subject to employment tax in cases in which no salary is paid to the sole shareholder of a business. And it may do that in situations in which the S-corporation pays the shareholder receiving the distribution no, or an unreasonably low, salary.
This makes getting money from a closely-held chiropractic practice while reducing the tax bite that normally accompanies the withdrawal increasingly more difficult under our tough tax rules.
Your best bet: By employing salary and distribution ratios and other tax strategies — and with the assistance of a qualified tax advisor — it is possible and affordable to get money out of any closely-held chiropractic practice or business while avoiding a challenge by the IRS for “unreasonably low compensation.”
Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.
DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.
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