Note: Paul S. Hamann and Jack Salewski, CPA, CGMA, wrote this post, which was originally published on the RCReports blog. Republished here with the author's permission.
We find it perplexing how often S corp. owners—who invest in their business with an eye on the future and carefully analyze the cost/benefit of every decision—take a short-term, simplistic approach to reasonable compensation: Just pick the lowest possible number to minimize payroll taxes.
A reasonable compensation calculation impacts far more than just this year’s payroll tax. Talking with your clients about the benefits of accurately establishing compensation can be a life saver in retirement, sale, or transfer of the business, or in the event of disability.
Some issues to consider are:
- Social Security income when in retirement;
- Greater retirement plan contribution deductions;
- Enhanced cash flow if there is a need for disability income;
- A higher 199(A) deduction for some;
- Business valuation; and
- Peace of mind.
More Social Security when in retirement
We have all heard, “Social Security will not be around when we reach retirement age,” or “the system is going broke.” While the Social Security system will certainly evolve and change, it’s foolish to put all bets on its total demise. In some form, it will be there when your clients retire.
Social Security benefits are based on the highest 35 years of earnings. The more Social Security compensation, up to the Social Security maximum, the greater the Social Security benefit in retirement. Once salary is at the Social Security ceiling, there is no more benefit.
Greater retirement contribution deduction means a more comfortable retirement
If your client remains convinced Social Security is a goner, retirement plan savings become even more critical, and reasonable compensation impacts that, too. The size of the retirement contribution deduction depends on: (1) type of plan; (2) the taxpayer’s age; and (3) compensation amount.
For example, if the taxpayer’s plan allows a 55% contribution rate, and the shareholder is paid $140,000, the deduction will be $77,000. If the compensation is adjusted to $300,000, the deduction would be $165,000. Assuming a 37% federal tax rate, this generates a tax savings of $32,560. There would be an additional Medicare tax of $3,344, giving the taxpayer a net tax savings of $29,216 plus state tax savings. Even if all the wages are subject to Social Security, there would be a net savings of $19,096.
With additional amounts paid into the retirement plan plus the deferred tax savings on earnings in the plan, the balance will be substantially higher than a regular investment account. The higher balance will enable the shareholder to take more money out of the plan to cover cash-flow needs.
Enhanced cash flow if there is a need for disability
It does not matter whether it is a private disability policy or SSI disability, benefits are based on earned income. For SSI disability, this could include children.
For some, a higher 199(A) deduction
There are circumstances when having higher compensation will increase the 199(A) deduction.
Business valuations will be cleaner
Every business valuation specialist and potential buyer looks at compensation. “Explaining away” an unreasonable compensation figure is not what an S corp. owner needs to be doing when selling the business. If the compensation figure is not reasonable, financial statements will need to be adjusted, which takes time and money. A proper calculation done as a matter of course will make eventual valuation work quicker and less expensive, and the seller will appear more professional and trustworthy. If it’s a divorce precipitating a valuation, the compensation level will be more credible than if it’s adjusted on the fly. If the valuation is needed for estate purposes, a valuator probably won’t have enough information to even calculate a proper amount, making probate even more stressful and contentious than it already is.
Peace of mind
In the recent past, all our worlds have been turned upside down. Why add an unnecessary worry about an IRS challenge? Or worry about cash flow in retirement or in case of disability? Or being able to sell the business for its true worth?
Each client situation and goals are different. Each situation needs to be evaluated objectively considering both short-term and long-term objectives and goals. The understatement of compensation is a short-term reward. Greater long-term rewards come from getting it right.
Learn more about RCReports and how to normalize compensation for owners of closely held businesses with this recording of BVR’s webinar, Normalizing Compensation for Closely Held Business Owners Using RCReports, featuring Paul Hamann.
About the authors: As founder and president of RCReports, Paul Hamann is an expert on determining reasonable compensation for closely held business owners. He has educated more than 80,000 tax advisors and valuators on the topic of reasonable compensation and has been published in numerous state CPA society journals.
Jack Salewski, CPA, CGMA, is vice president of education at RCReports and is an expert on the topic of reasonable compensation as it applies to S corp and small closely held businesses. Jack is also the owner of Jack Salewski, CPA, a firm that focuses on tax planning, strategic operational planning, and tax preparation for small and medium-sized businesses.