Maximizing Tax Savings for Entrepreneurs: Understanding Reasonable Compensation for LLCs and S Corporations
Chances are you’ve seen something online about the potential tax savings of switching from an LLC to an S Corporation. However, most of these articles and videos gloss over the most important input of this decision – how much to pay yourself. The IRS call this “reasonable salary or reasonable compensation.” This figure, along with your total net profit, are the most important numbers to look at when determining the most advantageous entity for your business.
Myths surrounding reasonable compensation
There are several myths floating around about how to determine reasonable salary. Some say to take 50% of your profits as reasonable compensation and 50% as distributions. Some say to set your reasonable compensation at the Social Security maximum. And there’s plenty of other advice that’s not rooted in any fact, such as ‘just take $40,000 or $75,000’.
The courts have been reliable in debunking these myths, although many accounting professionals and business owners still aren’t aware of the rules the IRS has established.
How to determine reasonable compensation
The reality is that the IRS has determined three approaches that it deems acceptable to determine reasonable compensation. The most common approach among our clients is the Cost Approach, also known as the “Many Hats Approach.” This is based on the idea that you perform several different functions for your business and each function is entitled to a different cost.
In addition to choosing the correct approach, you’ll want to document your reasonable compensation calculations and make sure you’re using unbiased data in those calculations. If you don’t have reliable data to back up your calculations, you’re putting yourself at risk of a lengthy reasonable compensation IRS audit.
So, LLC or S Corp?
Once you have determined your reasonable compensation figure, you can calculate whether it’s more advantageous for you to be taxed as an LLC, Sole Proprietorship or S Corporation. Make sure that you consider the impact of payroll taxes, as well as any additional fees associated with being an S Corp, such as payroll fees, bookkeeping fees, state licenses, etc.
What you pay yourself impacts saving for retirement
Many business owners do not realize that how much you pay yourself from your business has a direct impact on what you can contribute to your 401(k) or SEP IRA. If you pay yourself too little through payroll, your retirement plan contributions will be limited and you may not have enough money to retire. The same is true with Social Security benefits. On the other hand, if you pay yourself too much through payroll, you risk overpaying your Social Security taxes.
Therefore, you need to identify the “sweet spot,” where the amount you pay yourself through your business is “just right.” Not too low to trigger an IRS audit or underfund your 401(k) or SEP IRA. And not too high to overpay your social security taxes.
Our CPA firm calculates this payroll sweet spot for our clients. Give us a call if you would like us to do the same for you!
In summary, while filing as an S Corp has the potential to save you thousands of dollars on your taxes, you need to fully understand what your reasonable compensation should be (and document that figure!) so you can protect yourself and your business should the IRS come knocking.
Thank you to Paul Hamann of RC Reports for contributing to this article.
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Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audits and small business accounting and bookkeeping.
