A great tax-saving feature of S-corporations is that the net earnings are exempt from self-employment tax. But the tradeoff is that S-corp shareholders are expected to take a salary that qualifies as “reasonable compensation.” Since wages are subject to payroll taxes, this is an incentive to keep salaries low and save on payroll taxes, and to boost the tax-free cash distributions. The IRS is hunting for easy sources of additional tax and S-corp officer wages are a favorite target these days. IRS agents are especially eager if officer salaries are low in comparison to distributions. If the IRS reclassifies your distributions as wages, you’ll owe payroll taxes for those wages. And there may be penalties and interest thrown in for good measure.

How do you know if your compensation is reasonable? Of course, the IRS doesn’t define “reasonable compensation.” Instead they look at the following factors:

Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation

Another approach is to look at comparable salaries for your industry and region. Websites like Salary.com and Indeed.com are loaded with data that give you a good range. Year-end is the time to look ahead to next year and set your wage base for the year. While it’s possible to wait until year-end to recharacterize distributions as wages, you’ll have a better chance against the IRS if you set a consistent wage for the whole year. Please contact our office for our help in evaluating your S-corporation officer wages to help keep the IRS off your back.

This question came in to our office from a small food-manufacturing business. This was why this client was seeking the extra value of working with a CPA. Here are the questions we asked to help them find the answer:

  1. What are you using now? What’s the cost of that? Is it causing a bottleneck in your customer service? Will this help to grow your business to the next level? They had been using a personal vehicle with limited capacity. This meant more time spent driving and delays in delivery.

  2. Is this the best use of capital at this point in your business’ life cycle? What’s the state of your other equipment? Would it be better to upgrade some of that to increase your manufacturing capacity? Their equipment was either fairly new or had recently undergone a major upgrade, so a delivery van seemed like a good choice.

  3. How much will this cost? Can you find a used van that will serve your needs for the immediate term, or do you want to invest in a new one that will last longer? What about leasing? For this young company, a used van was the best choice.

  4. How will you finance this? Will you buy a used van with cash on hand, or will you need to finance this with a bank loan? With little cash on hand, an equipment loan was the best option. They already had a good relationship with a banker and were making steady payments on another equipment loan.

  5. Do you have the cash flow to cover loan payments in addition to your other costs? To answer this, we ran a cash flow projection under several scenarios, including the tax benefits of a purchase. By looking at the whole picture, we determined that while cash flow would be tight, the tax savings made this an overall good choice.

Is your business facing a similar decision about equipment purchases? Give our office a call, and we’ll help you determine the best options for your situation.

Since 1981, the Research and Development Tax Credit, known as the R & D Credit, has been repeatedly extended for a year or so at a time, only to lapse and be extended again. The signing of the Protecting Americans from Tax Hikes (PATH) Act on December 18, 2015 was a true game changer because this credit is now permanent and better than ever. The uncertainty about its fate is gone, which makes it easier to estimate the true costs of research and development.  For small businesses, the credit can now be used against Alternative Minimum Tax. And startups, which may not owe any income tax for the first few years, can now use it as a credit towards payroll taxes.

The R & D Credit isn’t just for companies with scientists in lab coats. It’s estimated that only one out of every 20 companies eligible for this credit claims it. This credit is for any company that applies science to design, develop or improve anything they do or make. All that’s needed is investing time, money or resources to advance or improve a product or a process. A key to claiming this credit is good documentation of the process from concept through trial and error to commercial release or deployment of the new product or process. Companies as diverse as architecture firms, software developers, breweries, machine shops, construction contractors and furniture manufacturers have claimed this credit and saved on taxes. Call our office today so we can help you save with the R & D Credit.  

Put as much as you can in your 401(k) now, and you benefit in at least two ways. First, you save tax now. For 2016 and 2017, you can contribute $18,000 plus an extra $6,000 if you’re over 50. This translates to a potential tax savings of $9,504 if you’re over 50 and in the highest tax bracket. Now’s the time to start figuring out how much you’ll need to save each month for 2017. If your employer provides a matching contribution, that’s free money. So it’s smart to contribute at least that much.

The second big benefit is the power of compounding interest. Susie Saver started putting away $6,000 a year at age 20. If she keeps that up until age 65, and gets a 5% return, she could have $984,000 when she’s ready to retire. Her total investment would be $270,000. In contrast, Steven Spender waited until age 45 to start saving. He would need to put away about $27,600 per year to catch up to Susie. Steven would invest $552,000 over 20 years, over twice the amount that Susie needed. Susie gets more bang for her buck by starting early. She’ll also have an easier time putting money away each month for a rainy day fund or for big purchases like homes or cars. Even if you’re over age 50, you can still benefit from compounding interest. Please call our office so we can help you reach your savings goals.