hey it's patti scharf CPA and co-founder of catching clouds the leader in
e-commerce accounting today I want to talk about something that a lot of S
corporation owners either miss in the discussions with their tax CPAs or it's
not brought to their attention or whatever but it is a huge red flag for
the IRS and this is reasonable compensation so let's jump right on in
just to remind everybody we do not actually do taxes this knowledge is
really from a prior life so I want to make sure that you guys are talking to
your tax CPAs to get advice on your own personal tax situation so what is
reasonable compensation so to really understand this I need to give you a
little bit more context so I'm going to use an example let's say that you're
making $200,000 as a sole proprietor so sole proprietor is basically the
simplest business entity type there is you just say hey I am a business and
poof your business okay so if you're a sole proprietor you're filing on
Schedule C on your individual income tax return okay
when you are filing this let's say you make $200,000 you're going to pay
federal income tax you're going to pay state income tax and you're going to pay
what's called self-employment tax you are self-employed you pay the
self-employment tax it's 15.3% okay you do get a deduction for half of that
yada-yada I want to keep this simple so fifteen point three percent is thirty
thousand six hundred dollars if I did my math right okay now if you instead
decide to file as an S corporation you file an election let's say you're a
limited liability company you file an election to be treated as an S
corporation okay that has a different set of rules and basically what an S
corporation does the IRS has basically said okay if you're an S corporation
then you as the owner really have two roles
you're wearing two different hats one hat is the employee hat the other hat is
the investor hat so as an employee of the business you you get to like pay
yourself wages so you pay yourself just like any other employee you're going to
pay federal income tax on that money you're going to pay state income tax on
that money but instead of self-employment tax you're gonna pay
what's called FICA which is your Social Security and Medicare tax okay and that
is seven point six five percent the employer is gonna pay another seven
point six five percent if you have those together it's the fifteen point three
percent that you were paying in as self-employed okay just get I'm not
gonna get down into much of the details but but this part is kind of important
with the other hat that you're wearing you're paying yourself as an investor an
investor in the S corporation pays federal income tax state income tax but
no self-employment tax no FICA okay so hopefully you see where
I'm going with this if you're a sole proprietor you're paying self-employment
tax so fifteen point three percent on two hundred thousand dollars as an S
corporation you're paying yourself you're paying tax on 15.3% of only the
employees wages okay so if you're paying yourself two hundred thousand dollars a
hundred thousand as an employee a hundred thousand as an investor you're
paying half the amount of payroll taxes right so there's an obvious incentive to
the taxpayer to minimize the amount that you pay yourself as an employee and
maximize the amount of that you're paying yourself as an investor the IRS
is aware of this the taxpayers are aware of this and so the IRS is specifically
looking for this on the tax returns they're going to be looking for people
who are not paying themselves wages if you have zero owners compensation you
are not paying yourself payroll taxes and doing that thing
the IRS is like dude stop defrauding us and
we are auditing you and you will lose that's it so the the IRS has this rule
called reasonable compensation which means you need to pay yourself a
reasonable amount of compensation to take advantage of this tax break so then
the question becomes what is reasonable and if you go to CPA and you say hey how
much is that how much can I pay myself where I'm minimizing taxes but I'm
flying under the radar and all of the good CPAs will say I can't tell you that
I cannot make that decision for you you have to decide for yourself so I'm here
to give you a little bit of just guidance and that is what you want to
pay yourself is what you would pay somebody else to do your job it's gonna
end up being a little bit different for everybody because it depends on what
kind of services you're providing to the company if there are just a lot of
different factors at play here so like I might not pay myself as much if I am
working 15 hours a week doing YouTube videos and have a team of people
supporting me as I might if I was the one doing all of the work in the
business as the only employee of the business you see what I'm saying so you
have to figure out what is a reasonable amount for you and the best way to do
that is just how much would you pay somebody else to do your job there's one
other thing to keep in mind is the IRS will look at this over like a multi-year
basis so like if you pay yourself less in one year and you pay yourself more in
another year to kind of make up for it they'll kind of like cut you some slack
and stuff on that but I get really nervous when I see people who are like
paying themselves twenty thousand a year like you're running the business like
this is your company you can't pay somebody else to run a whole company for
twenty thousand dollars a year so I'd say just keep that in mind absolutely
take advantage of the tax breaks for that if it fits your situation but just
don't take advantage of it just be reasonable all right
so the next questions going to be what payroll service should you use and this
is not a paid advertisement there are lots of different payroll services to
choose from choose the one that works for you but I will tell you that I
happen to love gusto we've been using it in our firm for five years with all of
our e-commerce sellers and I've heard nothing but rave reviews from other
people as well for at least the last couple of years okay and let me tell you
part of why they're so awesome one reason they're so awesome is you can set
it up for auto payroll like you can just say hey pay me X number of dollars per
month all year long it'll automatically calculate it and run and deposit it in
your bank and send the money to the government and file the payroll returns
with the government and you basically don't have to do anything the next
reason I like it is when you do that you're paying your taxes a little bit
over time so you're not hit at the end of the year with this gigantic tax bill
that you kind of forgot that you had to pay and oops you know I meant to spend
the money on this but I spent it on something else like it just kind of
takes care of that for you and helps you help yourself the next reason I like it
is that as you grow and you have to hire more people it's so easy to onboard new
people they've got like self onboarding you just like email the person that
you're hiring they'll send an offer letter you can offer benefits 401k and
health insurance and like all kinds of different stuff like it's a complete HR
service in fact they will also if you sign up for the concierge service then
they'll even like do employee manuals and be on call to answer all of your
questions and everything else so it's really one of those solutions that that
scales with you and it grows as you do and then shrinks down when you don't
need it you know what I mean it's it's just super flexible and they're awesome
and I love them and they're not super crazy expensive so yeah so I hope this
video helped you if I wanted to do it in December in particular because I wanted
to make sure that you had time to take action before the year ends you don't
wanna like show up in April with your tax preparer or March actually cuz your
returns are probably doing March and not have taken care of this critical thing
that needs to be taken care of for your business so I hope you found this video
helpful if you did please like comment and share if you haven't already please
subscribe and I'll catch you later