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Are You Optimizing S Corporation Owners’ Salaries for Tax Savings

Optimizing S Corporation OwnersAre You Optimizing S Corporation Owners’ Salaries for Tax Savings

Expert Tips for S Corporation Owners to Slash Taxes by Optimizing Salaries and Estimated Tax Tip Savings


Optimizing S Corporation Owners

Optimizing S Corporation Owners to Slash Taxes Salaries and Estimated Tax Tip Savings.

Variances in individual salary structures and profit distribution often result in scenarios where S corporation owners can lawfully diminish personal payroll taxes by $8,000 to $20,000 in the upcoming year.

The most effective approach for optimizing S corporation owners to reduce taxes that involves establishing an appropriate salary. This entails pinpointing your salary threshold—a balance that allows substantial savings on payroll taxes while meeting IRS criteria and mitigating audit risks.

This principle is clear: the lower your salary, the greater your payroll tax savings. Yet, setting it too low can prompt IRS intervention, leading to potential back taxes, penalties, and accrued interest.

Optimizing S Corporation Owners

Safeguarding your S corporation from IRS intervention while optimizing your personal income requires adherence to the IRS guidelines for establishing a sensible salary. Interestingly, these regulations are absent from the tax code, having been independently devised by the IRS. Until recently, uncertainty prevailed regarding the IRS’s approach in this domain.

Thankfully, three recent cases have illuminated the IRS’s strategy. It’s crucial for S corporation owners to familiarize themselves with these cases and utilize them as a reference when determining and substantiating their salaries.

This article helps in optimizing S Corporation salaries for tax savings owners simplify the procedure. We summarize the cases and subsequently distill that information into actionable steps, allowing you to safeguard your salary from potential IRS scrutiny effortlessly.

Reducing Payroll Tax Liabilities

Take this instance as an illustration of how reducing your salary can decrease payroll taxes. For instance, suppose you run a sole proprietorship and generate $100,000 in business income. In such a scenario, you would be liable to pay $14,130 in self-employment taxes, which are akin to payroll taxes.1

Tax Liabilities

By establishing an S corporation and fixing your salary at $50,000, both you and the corporation collectively incur $7,650 in payroll taxes.2 This configuration results in tax savings amounting to $6,480.

What occurs with the remaining $50,000 of your business income? You have the option to receive this remaining amount as a distribution and such distributions are not subject to payroll taxes.3

The IRS Reveals its Strategy

As the reasonable salary rule is not explicitly outlined in the tax code, our comprehension relies on observing how the IRS applies this rule in practical terms.4

Irs Strategy

The subsequent sections provide an overview of three key cases that most clearly elucidate the IRS strategy in this particular domain. Subsequently, we amalgamate the insights from these cases into actionable steps, empowering you to protect your business.

The Cases

Gavel and books

Watson Challenges the IRS

David Watson, an accountant, conducted business operations utilizing an S corporation structure. His S corporation held a 25 percent partnership in an accounting firm.5

Throughout the relevant years, Watson’s firm remitted payments exceeding $200,000 to his corporation. However, Watson opted for a salary of merely $24,000.

The IRS’s expert in valuation, Igor Ostrovsky, assessed the earnings data of accountants in Watson’s geographical region. As a result of his analysis, he arrived at a reasonable salary estimation of $91,044 for Watson, employing the following logical steps:

  • Ostrovsky initially analyzed accountant compensation reports, notably focusing on the Management of Accounting Practice survey carried out by the American Institute of Certified Public Accountants.
  • His assessment indicated that an employee without investment interests would typically receive $70,000 in compensation. Considering that owners billed at rates approximately 33 percent higher than directors, he increased the $70,000 figure by 33 percent.
  • Following this adjustment, he subsequently reduced the calculated amount of $91,044 to account for untaxable fringe benefits.

The court sided with the IRS expert’s assessment. However, it wasn’t entirely negative. Despite a salary set at $91,044, Watson could still receive the majority of his income as distributions exempt from payroll taxes, resulting in considerable savings compared to what he’d owe as a sole proprietor.

Nonetheless, Watson’s situation didn’t conclude entirely favorably. He faced payment of $23,431.23 in outstanding payroll taxes, penalties, and interest.

McAlary Opts for No Salary

Sean McAlary, a businessman, ventured into the real estate industry a few years before the housing market crash occurred in 2006.6

Experiencing swift success, he received a $240,000 distribution from his corporation that year. Despite being entitled to a $24,000 salary according to corporate records, McAlary chose not to take any salary.

For consultation on this case, the IRS engaged the same compensation expert involved in the Watson case, Igor Ostrovsky. Employing a similar methodology as in the prior instance, Ostrovsky determined that McAlary’s reasonable salary should amount to $100,755:

  • Ostrovsky referenced the California Occupational Employment Statistics Survey, discovering that the median wage for a real estate broker amounted to $48.44 per hour.
  • Calculating the potential annual income, Ostrovsky multiplied $48.44 by 40 hours per week and 52 weeks per year, despite the factual evidence indicating McAlary’s extensive work hours of 12-hour days with minimal days off.

In contrast to the Watson case, the tax court did not entirely endorse Ostrovsky’s conclusions, noting that determining reasonable compensation is “far from an exact science.

The court made a downward adjustment to Ostrovsky’s rate, settling at $40 an hour. This decision factored in the notion that factors other than McAlary’s individual efforts, such as a favorable housing market, contributed to his success.

Following the $40 rate, the court established McAlary’s salary at $83,200, allowing him $156,800 in distributions for the year.


Blodgett’s Salary Resulted in a Net Loss for the Corporation

Frederick Blodgett specialized in crafting glass blocks for various real estate applications such as windows, room dividers, and skylights. However, his business faced hardship due to the downturn in the Southern California construction industry in 2006.7

During 2007 and 2008, Blodgett provided approximately $55,000 in loans to his S corporation, Glass Blocks Unlimited. In those years, the corporation generated net business incomes of $877 and $8,950, respectively.

Despite Blodgett forgoing a salary during this period, he withdrew approximately $30,000 annually, which he reported as a combination of distributions and loan reimbursements. However, the court determined that these “loans” were essentially capital contributions and categorized the entire corporate disbursements to Blodgett as distributions.

The court agreed with the IRS assessment of Blodgett’s salary at around $30,000 annually, noting that individuals in Blodgett’s field of work would typically earn no less than that amount.8

It’s important to note that by stipulating a salary for Blodgett, the IRS and the tax court effectively resulted in his corporation incurring a net loss for the respective years.

Consolidating All Cases

In determining a reasonable salary, the initial step involves sourcing dependable wage statistics pertinent to your job and geographic area.

If your business entails multiple roles or if there’s uncertainty regarding the precise classification of your position, seek the closest analogous comparison available.

Upon discovering a salary or wage reference within the statistics, make reasonable modifications considering the disparity between your business and the typical business scenario. Here are instances where a downward salary adjustment might be appropriate:

  • Your business registers lower profitability compared to other businesses in the region.
  • You’re not engaged in full-time work.
  • Other factors beyond your individual efforts have significantly contributed to your business’s success, such as a beneficial housing market for a real estate broker or the nature of your owned assets.

Record and document your rationale within your corporate meeting minutes. This practice ensures that you maintain a documented record, substantiating your analysis for future reference and verification.

Warning Signs Regarding Salary

Warning Signs

The IRS is inclined to scrutinize compensation matters, particularly when an S corporation owner receives distributions without receiving a salary.

When your corporation faces financial losses, you are not obliged to receive a salary.9 However, if you opt not to take a salary, it’s advisable to reduce or entirely refrain from distributions until a fiscal year in which you do receive a salary.

Key Takeaways

Casual Gambling

As an S corporation owner, lowering your salary reduces payroll taxes. This tax-saving tactic is permissible by the IRS, provided you don’t diminish your salary below a “reasonable” threshold.

To establish a reasonable salary, adhere to these steps:

  • Reference salary data pertinent to your industry and location.
  • Consider downward adjustments to the statistical salary, justifying these modifications—perhaps due to your business being less profitable than average or working part-time.
  • Record and substantiate your analysis in your corporate meeting minutes.

Lastly, abide by this fundamental rule: abstain from taking distributions if you opt not to receive a salary. Receiving distributions without a corresponding salary can trigger IRS scrutiny.

Note: The court deliberated on an hourly rate for Blodgett, but a comprehensive salary analysis was not conducted in this instance, potentially due to the minimal net income of Blodgett’s business. The court determined that the distributions taken by Blodgett equated to at least a reasonable salary.


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1. Self-employment tax rate of 15.3 percent is applied to 92.35 percent of the $100,000 self-employment income, resulting in a net self-employment tax of $14,130. Refer to Schedule SE for details
2. $50,000 x 15.3 percent
3. Refer to IRS Revenue Ruling 59-221.
4. Consult IRS Fact Sheet 2008-25.
5. Case: Watson v US, 668 F.3d 1008 (8th Cir.)
6. Case: Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62.
7. Case: Glass Blocks Unlimited, TC Memo 2013-180.
8. Note: The court deliberated on an hourly rate for Blodgett, but a comprehensive salary analysis was not conducted in this instance, potentially due to the minimal net income of Blodgett’s business. The court determined that the distributions taken by Blodgett equated to at least a reasonable salary.
9. Refer to Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618.