Compensation issues for self-employed S corp. owners.

• Author: Hwang, Angela L.J.

Many owners/sole employees of small businesses set up S corporations on the advice of their tax advisers and compensate themselves with wages and profit distributions. Some of them pay themselves a low wage to save on employment (FICA) taxes and then get in trouble with the IRS because their wage is not "reasonable." The end result is that they owe back taxes, penalties, and interest, and they will also have missed some important retirement contribution options. This item discusses how reporting a higher wage can actually maximize long-term profits for the owner-employee of an S corporation.

S Corporation Owner Compensation

If the owner of an S corporation provides services to the S corporation, part of the business income can be considered wages and the rest as a distribution. The range of wages earned by the owner-employee must be reasonable with regard to services rendered and must follow IRS guidance. However, there is discretion in determining a wage payment.

To illustrate the effects of different wages, this item compares the income from two S corporations. (A downloadable and interactive spreadsheet is available at http://ahwang.pageout.net; under the "Research" rink, click on "Course Content," then select" Taxation.")

Example: A Corp. and B Corp. each earned $200,000 in income before wage and retirement contributions (IBWRC). Because the owners of both companies are also employees, each will earn a wage. Their companies will be able to deduct this wage as an expense and must pay FICA taxes. A is run by L, who pays himself a low salary of $15,500. H, the owner/employee of B, pays herself a high wage of $122,000.

Since L pays less in FICA taxes, it might be logical to assume that his tax burden would be less. However, if H is able to maximize her retirement contributions with a retirement plan such as a solo 401(k), her taxes will be surprisingly lower after future Social Security benefits are factored in.

The Advantages of a Solo 401(k)

Many options for retirement planning are available to the self-employed, such as profit-sharing plans, simplified employee pensions (SEPs), Keoghs, SIMPLE IRAs, and solo 401(k)s. A solo or self-employed 401(k) combines a profit-sharing plan with a 401(k) plan and allows a sole owner-employee to make greater tax-deferred contributions than would be permitted under the others.

The solo 401(k) has two components. First, it features an "employer" profit-sharing contribution component that allows the...