Another possible consideration is whether time spent on other enterprises affects the salary-distribution allocation. What if John also sells cars in a proprietorship for which he reports all net profit as self-employment income on his IRS Form 1040? He devotes 75% of his time to the car sales and 25% to managing the bookkeeping business. Can John now consider only 25% of the S corporation business as his earned income subject to wage taxes?
In determining the tax savings, there are other considerations besides FICA and FUTA taxes. Many states require expensive insurance for workers’ compensation and temporary disability as well as state unemployment taxes. Some vocations, such as roofers or high-rise window washers, pay workers’ compensation rates not too much below the actual wage cost.
Charles Leland, CPA
Authors’ reply: We appreciate Mr. Leland’s close reading of our article. Certainly he addressed further considerations that the CPA must evaluate in determining the “reasonable amount” of employee wages to be paid to owner-shareholders of S corporations. Certain of his comments reiterate the authors’ positions that “rules of thumb” should not be used and each S corporation is unique; thus each determination must be made based on all the facts and circumstances of the corporate activities, including an analysis of the shareholder-employee’s actions on behalf of the S corporation.
In answering Mr. Leland’s initial question, we believe the simple answer is that the profits are 100% John’s (the shareholder-employee “SE”). A question would then necessarily follow: “Which part of the profits should be allocated to John in a fair market return for the value of his services (and hence subject to SE taxes) and which part should be allocated to corporate profits (not subject to SE taxes)?”
His means of producing the “profits” was through the labors of himself and the six bookkeepers. The more appropriate questions might be how to bifurcate the “profits” into (1) salary for John and (2) an S corporation profit. We note that the marketing and management services provided by John are themselves personal services. We also note that John’s services are to the corporation rather than from the S corporation (as with the bookkeepers). The degree to which such a distinction would be relevant in shifting amounts away from wages and toward profits (thus not subject to self-employment taxes) is worthy of its own analysis. Undoubtedly, John provided the marketing and administration for good reasons, the most rational being to increase the productivity of the bookkeepers and hence the “profits” to the corporation.
The CPA should realize that the paramount consideration in such cases is that reasonable salaries should be reflective of the value of the owner’s services provided to the S corporation. We can see no reason that the provision of management services to the S corporation alone serves as a justification for avoiding self-employment taxes.
As to the car dealership proprietorship scenario, the approach seems straightforward—the value of the services provided by the CPA to the S corporation are all that matter. In such a scenario one would presume that the shareholder’s value as a lesser participant due to the large amount of time provided to the proprietorship (75%) would be substantially less than a year when the taxpayer commits full efforts to the S corporation. With multiple enterprises and professions, the taxpayer and CPA are advised to substantiate the services rendered in support of the tax return positions.
We believe it an oversimplification to report 25% of the S corporation profit as wages from an S corporation. We note as well that the participation in the bookkeeping service does not allow the car dealership proprietor income (Schedule C) to reduce the profits as self-employment from that business below 100%, thus a proportional approach to the S corporation profits would seem to fail for similar reasons. Again, a seemingly safer approach to the wages issue for the bookkeeping manager (SE) would be to determine that comparable full-time managers receive $X from similar positions (that is, requisite skills, time, geographic region, clientele, etc.) and take 25% of such amount as wages (subject to SE) due to the amount of the shareholder’s time contributed to the S corporation. Any remaining profit would then escape SE taxes (S corporation profit).
James A. Fellows, CPA, Ph.D.,
and John F. Jewell, CPA, J.D., LL.M
St. Petersburg, Fla.