I'd like to clarify the issue. Personally, I think that the CPA in question in the article is an idiot for a number for reasons. (1) He's an accountant so he should've known that playing this game with the IRS as a CPA is begging the IRS to slam you. (2) Litigating a losing position like this so publicly is going to kill your reputation and put you on the IRS' top 10 favs list for life.
This is a very clear issue actually and I'm not sure why there is so much confusion and I'd disagree with calling this tax plan a "trick."
It is a legally sound tax plan with a justified theory. You are allowed to exempt a portion of your income from payroll taxes because they are "corporation distributions." Corporate distributions or dividends are not taxed as earned income because they are considered passive investment income. An S-Corp is a corporation that abides under a specific subset of rules within the IRC's Corporation Regulations, thus it is for all legal purposes a regular corporation with certain special rules.
A reasonable salary is a fairly straight forward question. The IRS won't nitpick with you on silly numbers as long as you fit within the range. Obviously, for every position there is a high and low salary range, so as long as you fit within that range the IRS will leave you alone.
The CPA is an idiot because he underpaid himself below market rates to the point where he couldn't justify his position under any reasonable defense.
If you were developer, then you would be paid anywhere from 40k to 250k+ depending on your company, position and experience. Thus, you could potentially pay yourself 40k in reasonable salaries if you owned an S-Corp and take the rest as a dividend. As long as you are able to provide "comps or comparable salaries" to positions with equitable responsibilities and experience in your local region.
The important thing to remember is to be reasonable.
I'm a full-time tax accountant, so this is coming from years of experience in the field with direct contact with auditors from the federal and state levels. They won't come knocking unless you were being a greedy idiot because like the article states it's expensive for the government to audit someone, so when they do audit you it has to be a profitable venture (thus, they usually audit the sure-thing losers).
Does any of this apply if you're not distributing the cash at all? Say, I am making money in my S-Corp, but I keep all of it in the bank (minus the expenses) and instead live off my savings. The plan is to save enough to expand the business, but for now the money is just sitting there, doing nothing.
No that is not going to work. Keeping money in the business is called "retained earnings." Only C corporations or regular corporations are allowed to retain earnings. Pass-through entities such as partnerships and S-corporations are required to pass any income to the owners regardless of whether cash or any other form of income is distributed.
If you want to reinvest into the company, then you'd have to pay taxes on the distributed income and then put the after tax money back into the business, which would increase your tax basis in the company. This would allow you to take net operating losses in the future as well as help you if you ever sell the company.
Hope that helps. Keeping money in the bank won't help you in this situation.
Thanks for your reply. Just to be sure I understand you correctly, which one (if any) is true:
If an S-Corp makes money, it is assumed that the earnings are distributed and thus both personal income tax (on the entire earnings amount) as well as payroll taxes (on the reasonable wage) have to be paid.
Or:
If an S-Corp makes money, it is assumed that the earnings are distributed and the personal income tax has to be paid (on the entire earnings amount), but payroll taxes don't need to be paid.
Option 1 sounds about right. All distributions are going to be tax on your personal income tax and exempt from payroll taxes.
Reasonable wages are NOT corporate distributions, they're simply wages paid by the corporation and deducted as an expense. The payroll taxes would be paid on the amount that you deem wages through the corporation. Please note, payroll taxes are also deductible. hope this helps
This is a very clear issue actually and I'm not sure why there is so much confusion and I'd disagree with calling this tax plan a "trick."
It is a legally sound tax plan with a justified theory. You are allowed to exempt a portion of your income from payroll taxes because they are "corporation distributions." Corporate distributions or dividends are not taxed as earned income because they are considered passive investment income. An S-Corp is a corporation that abides under a specific subset of rules within the IRC's Corporation Regulations, thus it is for all legal purposes a regular corporation with certain special rules.
A reasonable salary is a fairly straight forward question. The IRS won't nitpick with you on silly numbers as long as you fit within the range. Obviously, for every position there is a high and low salary range, so as long as you fit within that range the IRS will leave you alone.
The CPA is an idiot because he underpaid himself below market rates to the point where he couldn't justify his position under any reasonable defense.
If you were developer, then you would be paid anywhere from 40k to 250k+ depending on your company, position and experience. Thus, you could potentially pay yourself 40k in reasonable salaries if you owned an S-Corp and take the rest as a dividend. As long as you are able to provide "comps or comparable salaries" to positions with equitable responsibilities and experience in your local region.
The important thing to remember is to be reasonable.
I'm a full-time tax accountant, so this is coming from years of experience in the field with direct contact with auditors from the federal and state levels. They won't come knocking unless you were being a greedy idiot because like the article states it's expensive for the government to audit someone, so when they do audit you it has to be a profitable venture (thus, they usually audit the sure-thing losers).