The S-Corporation

For the purpose of taxation, an LLC may be classified as an S-Corporation and similarly a Sole Proprietorship (after applying for an EIN number) can also be taxed as an S-Corporation. An S-Corporation divides Business Income into 2 components; Wages (aka Salary) earned and "Business Profits". The main reason for setting up an S-Corporation is to be able legally to exclude "Business Profits" from self-employment taxes with only Wages being taxed (at the current high rate of 15.3%). Under proper circumstance, and with the help of our service, you can enjoy considerable tax savings. You, as a business owner, will technically be an employee of your own S-Corporation and the Wage component of your total Business Income must be "reasonable", according to the IRS.

Business Income = Wages (15.3% self-employment tax) + Business Profits (no self-employment taxes)

"Reasonable Wage"/Business Income = % Reasonable Wage

Two extreme examples, for illustration purpose:

Example 1: You developed software that people automatically download and pay for on your website. Your business generates profits of $100,000 "without you having to lift a finger". All you do is make sure periodically that the web site is functioning. A "reasonable wage" is considered what another person (in your absence) should be paid for htis activity. Monitor the website for a few hours a day does not require any particular expertise. Lets' say we determined this labor to be valued at $10,000 for the year. Therefore, reasonable wage is only 10% ($10,000/$100,000) of the Business Income. Therefore, most of the income could be excluded from self-employment taxes.

Example 2: You are a physical therapist working with patients 8 hours a day. Your business generates $100,000 in profits. Most of the business profit is generated with complete hands on involvement in the business. Another person, taking over your role, requires specialized training and expertise in physical therapy and would typically be making $75,000/year in wages. In this example, the % of Reasonable Wage would be 75% ($75,000/$100,000). Only 25% of total Business Income can be excluded from Self-Employment taxes. The advantages of an S-Corporation classification would be considerably less than in Example 1.

Your situation falls somewhere in between these 2 extremes. The IRS takes into account multiple factors to determine what should be considered a reasonable salary. An unrealistic or underestimated salary % may trigger an IRS audit and subject the taxpayer to fines and/or back taxes with interest.

Let Everyday Accounting help you determine your "reasonable wage". We rely upon 7 factors toward determining this:

1) How active or passive are you, personally, in generating your business income.

2) How many hour per week are you active in your position.

3) What level of expertise do you have for your position.

4) Can you be easily replaced by another individual to do your work.

5) How much are others in your position, and in your city, being paid for similar work.

6) Are there any extraordinary expenses to be taken this year.

7) Have you ever been audited by the IRS.

You should indeed ask yourself an "objective question":

How much would I pay someone else for the work that I do.

Take the Business Income from Schedule C and divide it by this Wage to determine a reasonable percentage.

Statistically speaking, here are "Reasonable Wage" percentage ranges with the likelihood of IRS scrutiny:

10%-30% ( Highly Scrutinized - Must Be Justified, Requires Careful Consideration )

40%-60% ( Possibly Scrutinized - May Require an Explanation )

*70%-90% ( Low Likelihood of Scrutiny )

Not all predictable however!

Take the example of a business taking a large business expense resulting in a low Business Income. The ratio of Wage to Business Income would seem high (a low likelihood of scrutiny). For example, let's say Sales for the business was $75,000 and expenses were high at $50,000 resulting in Business Income of $25,000. If our "Reasonable Wage" was reported to be $20,000, there would seem to be a low likelihood of scrutiny at 80% ($20,000/$25,000). If the large expense was not taken (Business Income instead now at $75,000 and Wage at $20,000), the ratio could seem low and suspicious at 27% ($20,000/$75,000). Is this taxpayer evading self-employment taxes by artificially lowering their Reasonable Wage by inflating their expenses? The IRS computers may "red flag" this return.

You can get a wage estimate for someone with your job title at the Payscale web site. The IRS uses sites such as this to verify Reasonable Wage claims.

As an example, if your Business Profit is $75,000/yr and reasonable wage for your work is $25,000, then the reasonable wage % would be 33.3%. To estimate your tax savings, enter these numbers into our savings calculator. You could save about $5240 in the first year and even more in subsequent years.

EveryDay Accounting can assist you in determining what % of Business Income could be considered Reasonable Wage in your situation and will proceed with payroll withholding and tax returns using this decision. However, this decision is yours and EveryDay Accounting cannot be responsible for under withholding that may trigger an IRS audit and the consequence of paying back taxes, fines and penalties. We request that you do some additional research.

Please use our "Savings Calculator" to determine if it is worthwhile to pursue an S-Corporation at your Business Income level and "Reasonable Wage" percentage.

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