Newsletter from
Steve Richardson & Company
Certified Public Accountants
December 07, 2022
W-2 Wages and Reasonable Wages
To Our Clients and Friends:
Sub-S Corporations can be important in a tax plan
Sub-S Corporations can be an important part of a tax planning strategy. I personally like to use them in tandem with LLCs to create financial structures that are tax and financially efficient.
For tax planning to be successful …
The success of tax planning depends upon two essential factors:
- Quality books and records.
- Predictable Profits.
The meaning of “quality books and records” is obvious. Your accounting should be fair, accurate and honest. Just to be clear, “fair, accurate and honest” means that you obey the tax laws. If you fail this1st step, tax planning will do far more harm than good.
Tax law is complicated. With no intent whatsoever, you can accidentally violate tax law. Thus, the need for tax professionals. In highly technical areas, such as tax law, reliance on tax professionals is important.
The second essential factor, profits, is also obvious; without profits, tax planning is the least of your problems. (Side note: we have a consulting practice that can help businesses with non-tax problems.)
Sub-S Corporations can have pitfalls
A few weeks ago, I saved a client from a $36,179 IRS bill created by a Sub-S tax trap. Unintentionally he violated tax law. I saw the mistake and corrected the error. He is grateful and happy that I know how to apply tax law.
The 1st Mistake with S-Corps!
The1st mistake people make with S-Corps is thinking that they are simple and easy to operate. S-Corp stands for “Small Business Corporation”, which translates to most taxpayers as something designed to be simple and easy to operate. S-Corps are complicated! There are literally dozens of ways to make serious tax mistakes in an S-Corp environment. When we do S-Corp tax returns, we keep our eyes open for possible errors and misapplications of tax law. That’s how I saw this very expensive mistake.
The number-one most common S-Corp mistake!
An unexpected tax bill of $36,179 would put a dampener on any day.
Let me give you the background. This is not a wealthy family nor an extremely profitable S-Corp. Their S-Corp earns a bit less than $100,000 each year. Not bad, but not wealthy either.
The problem is that they did not have a “reasonable wage”.
A reasonable wage
The law is clear. Every S-Corp must pay its owners who work in the corporation a fair and reasonable wage. The wages cannot, by law, be too low. Having $15,000 wages in an S-Corp earning $100,000 is too low.
The unreasonably low wages described above triggered an unexpected tax of $36,179. I do want to emphasize that this is not hypothetical. This is as real as it gets.
The calculations
The risk
The risk of unreasonably low (or no) wages is too high. These are not hypothetical calculations. I have seen the IRS nail these penalties to people of modest income. Penalties this high can create financial hardships. As your S-Corp income increases, these penalties increase too.
Notice in the above calculations that the IRS will go back to the three open years. Thankfully we have the Statute of Limitations in tax law that limits the damage the IRS can do.
What happened?
When I saw this penalty situation, I immediately contacted the client and corrected the situation. I instructed Liz (Liz handles payroll issues for the Firm) to set up a W-2 for our client in the amount of $45,000. In this situation, I consider $45,000 to be reasonable.
What is Reasonable
Reasonable is a matter of professional judgement. The tax professional and the IRS must consider all the “facts and circumstances” and the relevant case law to arrive at an estimation of a reasonable compensation.
Estimation
That word, estimation, throws some people. There is a sharp difference between a “professional estimation” and a layman’s estimation. Do not confuse the two. The difference is vast!
Do you have an S-Corp
If you have an S-Corp or know of someone who does, please set up a phone conference with me or one of our staff to discuss the topic of reasonable compensation.
We may need to increase your W-2 reported wages as a matter of financial security.
Sincerely,
Steve Richardson, CPA