Reasonable Salary/Distribution

[geekgirldany]

I thought I had posted about this before but I can not find it.

S-Corporation. Officer/sole shareholder has been taking low wages for the past 5 years. Anywhere from $10,000 to $16,000. During this time he did not take out any shareholder distributions. I tried to explain to him that he needed to pay himself more and take distributions. The money is there. Well now the corporate bank account has built up to $300,000. All retained earnings. He told me he though of it as a savings account.

Since the bank account has reached this amount he is wanting to just take the money out. Do $50,000 payroll and take the rest as distributions. Do you guys think that would raise a flag? I mean to me I think there would be a chance of some of it being reclassified as payroll.

I would like for him to do equal amounts. Say $70,000 payroll and then $70,000 distributions. The company owes him around $20,000 on a loan. So he would get that back. He is also wanting to do a Solo 401K and investments.

I've been working with him on this for several months. He believes he should be able to take the money out. I've never had a customer with this type of problem. Too much money in the bank. Most of the time if it is there people take it out.

Would appreciate any advice on this.

[ChEAr$]

MONEY money money

First make sure that his salary is reasonable for the work performed. For comparable
salaries visit web site for roberthalf and look around (so I'm told; I've never looked myself
even). But this was a subject discussed at our recent spring seminar at Jekyll Island
sponsored by GAEA.

Salary and cash accumulated have nothing to do with each other. It's his money by virtue of corporate ownership and he may withdraw as he sees fit.
Naturally the 20,000 loan to the corporation should be paid first.

In one case long ago, the sole stockholder didn't notice the cash built up and as a result,
since Alabama taxed corporations on net assets at that time, his annual franchise tax was
quite high. So on my advice before Dec 31st every year, he brought the bank balance
down to reason with a generous Christmas distribution.

[geekgirldany]

Okay thanks I wasn't sure. Looks like he should be paying himself between $58,000 to $68,000. I was just a little concern because of previous years where he took very little in salary. I guess it would be fine for him to take $200,000 as distributions since he has not been taking any out at all in previous years.

[erchess]

I am confused

I thought that an S Corp was deemed to distribute all the profits by the end of the year in which they were earned. I also thought that any other monies that came in were deemed to be distributed unless otherwise spent by the last day of the year. Help Help oh help and bother!!!!!!!

[ChEAr$]

Deemed

I thought that an S Corp was deemed to distribute all the profits by the end of the year in which they were earned. I also thought that any other monies that came in were deemed to be distributed unless otherwise spent by the last day of the year. Help Help oh help and bother!!!!!!!

"Deemed"? By whom?

Certainly there is no requirement that monies actually be distributed at year's end.

Also remember that the accumulated earnings tax does not apply to S corporations.

Come to think of it, I haven't visited that aspect in quite a while now. Is there still
such an accumulated earnings tax for C corporations?

[erchess]

Deemed by the IRS

in other words I thought that if the corp made a profit or simply had cash on hand at the end of the year that money was taxable to the shareholders without regard for whether it was actually given to them or not.

[snowbird]

G

This thread is a little confusing. You said that "been working with him on this for several months." I assume you have seen the 1102S, K-1's and his 1040 for previous years? Is he DIY'er, if so he would not be the first to hear that S corp's pay no taxes and therefore leaving the money in the corp and not take it to his own income tax through K-1.

He can leave money in his corporate bank account (call this retain earnings if you want), but the earnings each year had better flowed through to his 1040 and have been taxed. I know I am being very basic here, so don't mean to insult anyone, it is just the thread suggest this did not happen.

[geekgirldany]

I've been doing the taxes since his second year in business. He has been in business for five years now I believe. The S-Corp income has flowed through to his 1040 and taxed. So taxes have been paid on the net income from the S-Corp. His salary during those five years would vary from $10,000 to $16,000. No shareholder distributions.

I guess my concern is that it will look a little strange to take so little salary during the last five years and no distributions to now take a $60,000 salary and $200,000 in distribution for 2008.. I just don't want the $200,000 reclassified as salary.

I said I have been talking to him about this the last few months. I go through this every year with him. He is a good guy and works very hard. I think this is the last thing on his mind at the end of day.

[JG EA]

How much would his business need if an emergency should arise? Operating expenses would still need to be paid. Payroll would still need to be paid . Having a few months money in the corporation could be for this. Or does the business plan to grow, buy a new building? If there is a good reason for keeping a certain amount of money this could be documented in minutes.

[geekgirldany]

He is the only one on payroll and then he has a few subcontractors. So he doesn't have employees but did tell me that he knows he will need to hire a supervisor very soon. Landscaping business.

What I would like for him to do is leave $100,000 in the bank account for operating expenses, subcontractors (if he was to get sick and not be able to work), and to eventually either rent or purchase a building to house his equipment.

One big thing on his mind is that he is afraid if anyone was to get hurt on the job and/or an accident happened someone could sue the S-Corp and get all the money. So he wants to get it out asap. I've explained that all he really needs is a additional umbrella insurance policy to cover the s-corp liability.

I want him to get the money out but in the correct way.

[JohnH]

I'd be inclined to strip out all the cash except for the bare minimum operating capital needed. He can always loan money back to the corp if he later finds out that took out too much. Since it's an S corp, anything not taken as salary has already been taxed anyhow, so taking it as a distribution has no tax consequences - it simply reclassifies it as belonging to him rather than the corp. Better that it be sitting in his personal account or a CD under his control rather than in the corp accounts where there's always the potential to lose it to a creditor or a legal claim if the worst happens.

He should absolutely max out a SEP IRA contribution. He can still put the max into a SEP IRA for last year's salary if there's an extension in place, plus he can fund the SEP for this year's salary as well. Clients overlook this detail all the time - they should fund their SEP to the max if it's at all possible. The SEP contribution bypasses FICA/Med tax completely, so it's very tax efficient.

Even if the corp runs short of cash a year or two down the road and part of the SEP must be withdrawn & put back into the corp, it's often cheaper than taking salary & then later loaning it back. That's because (in addition to income taxes) the salary would be subject to FICA/Med plus a matching amount from the corp, (15.3% total) when it came out. Allowing for the fact that the corp takes a tax deduction for the FICA/Med via the salary payment and matching payroll tax payment, both of which reduce net S-corp income on the shareholder's return, the actual combined cost is a net of roughly 11% after tax. When you compare that to the 10% non-deductible early withdrawal penalty, it's virtually a wash.

Add to that the fact that the money earns some rate of return during the time it's in the SEP, and that the return is on the entire principal (including the income tax portion), and it begins to make sense to fund the SEP to the max even if there's a possibility that some or all of it may need to be withdrawn if the company needs the cash later. If he's lucky and the corp doesn't need the money, it was a great tax-efficient investment strategy. If things go differently and he needs to reclaim part of it to fund operations, it hasn't cost him anything extra even after paying the early withdrawal penalty. In most cases, the strategy will make money after as little as 4 months - anything over that is a positive.

Finally, even if the salary exceeds the SocSec maximum, funding the SEP to the max still makes sense. Assuming that the money in the SEP in ins a very conservative investment earning about 3-4%, the complete break even point on the penalty still arrives somewhere between 9-14 months when you take into account that the income tax money is in the SEP earning a return until the income tax must be paid after the withdrawal is made. That really isn't very long, since each month that goes by will close the gap to some degreee.

The only other fly in the ointment would be if the state also imposes an early withdrawal penalty, but even in those cases there's a fairly easy calculation to make to determine where the break-even point lies.

[ChEAr$]

Money

in other words I thought that if the corp made a profit or simply had cash on hand at the end of the year that money was taxable to the shareholders without regard for whether it was actually given to them or not.

is not taxable. It is an asset and appears as such on the balance sheet of the corporation.
However what you're thinking of is ordinary income computed on page 1, whether or
not distributed to shareholders.

[ChEAr$]

Great analysis and exposition

John.

Let me add concerning the SEP, that corporate contributions to this are based on
salary, maximum 25% of it. Thus Danny, here is one more reason to get his salary
up where it should be.

[geekgirldany]

Wow! Thank you guys for posting. John terrific post!

I am going to recommend he takes atleast $68,000 in salary. If he wants to contribute more to a retirement plan then he needs to up it. I was leaning towards a Solo 401K because he could contribute an extra $15,500 deferred comp. if I remember correctly. He can then take the money in the bank account as a distribution and invest as he see fits. I thought about a money market account, CDs, maybe municipal bonds. It is now left up to him to make the decision.

Well I really do appreciate you all taking the time to post on this. First time I've ever had a customer not want to take money out of business and so much be left Usually it is the other way around.