S corporation salaries: how much is enough?

The idea of keeping your salary low seems counterintuitive to an entrepreneur.  The whole point of the game is to make money, right?  Well, yes, but sometimes there are better ways to make it than through salary, tax-wise. 

Many small businesses are conducted through S corporations.  These corporations - sometimes called "Subchapter S" or "Sub S" corporations after their home in the tax code - don't pay tax on their earnings.  Instead the earnings are taxed on the personal returns of the owners.   The S corporation reports its taxable income to the owners on Schedule K-1. 

Now these K-1 earnings are not subject to Social Security or Medicare tax.  That's why you might want to keep your salary down and your K-1 earnings up: the salary, reported to you on form W-2, is subject to a combined 15.3% Social Security ("FICA") and Medicare tax, up to the amount of the "FICA Base" ($102,000 for 2008).  The 2.9% Medicare tax applies to all salary, regardless of the FICA Base.  So if a business makes $100,000 and the owner takes zero salary but $100,000 on the K-1, he avoids $15,300 in employment taxes.  At least that's the idea.

The IRS doesn't care for this.  All new S corporations get a warning from the IRS that they have to pay "reasonable" salaries to working owners so they don't unfairly avoid employment taxes.  And there's the rub: they never really tell you what that means, and nobody really knows.

We can address the extremes easily enough.  If you have a profitable law or medical S corporation and you take no salary, the IRS will come after you.  And if you take all of your earnings as salary and none on the K-1, the IRS has to leave you alone. 

But what of the many situations in between?  If your corporation is losing money, does an owner-employee have to take a salary?  In IRS exams I've seen, no, but past performance is no guarantee of future results.  And what of a highly-profitable S corporation whose aging founder is stepping away from the business - does he still have to take a "reasonable" salary? 

One example that gained some notoriety involved former presidential candidate John Edwards.  His S corporation law firm made over $20 million one year, and he took "only" $360,000 or so in salary.  Can a $60,000 IRS agent assert that a $360,000 salary is unreasonably low?  At least without giggling?

There are no hard and fast rules in this area.  A good rule of thumb is the old tax maxim "pigs get fat, but hogs get slaughtered."  If you own a profitable business and work full-time there, and you take zero salary, you are asking for trouble.  But if you take a salary that reflects your role in the business, you should be fine, even if it's skinny.  After all, Warren Buffet only pays himself $100,000.  And remember, if you pay yourself too little, you may be cutting yourself out of tax savings in your company retirement plan.  In any case, business owners should run their compensation arrangements by their own tax advisors.