A popular income trick played by S-Corp owners is to take a
significantly deflated salary, and then collect large profit distributions. This
tactic lowers tax liability because income collected as salary is subject to a
2.9% Medicare tax and some is subject to a 12.4% Social Security, or FICA, tax.
By shifting that income to a profit distribution one can sidestep those taxes.
Recent IRS statistics have caused an increased scrutiny of S-Corp owners’
salaries. Over the past decade and a half, while executive paychecks exploded,
the salaries of S-Corp owners declined as a percentage of total income, from
52% in 1995 to 39% in 2007. During the same period, S-Corp income doubled,
while salaries increased only 26%. While many think that the IRS can only force
someone to take a salary decrease, a recent district court case showed that one
can also be forced to increase one’s salary. In David E. Watson P.C. vs. U.S.,
Mr. Watson, a CPA with 20 years of experience, took a salary of $24,000 in 2002
and 2003, and made profit distributions of $203,651 and $175,470, respectively.
Recent graduates with no experience earned an average of $40,000 at that time.
The court determined that a fair salary for Mr. Watson would have been $91,044,
and ordered him to pay back the nearly $20,000 he saved in payroll taxes as
well as interest and penalties. What S-Corp owners have going for them,
however, is that fair salary is a very gray area. While Mr. Watson’s salary was
low enough to attract the attention of the IRS, it would be difficult to prove
that a more appropriate salary is too low, even if it is on the lower end of
the spectrum.