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Reasonable Compensation and the Effects of S-Corporations Versus C-Corporations

In an S-Corporation, you’re dealing with the convoluted rules of reasonable compensation. As an S-Corporation shareholder, you will avoid self-employment tax. Self-employment taxes Social Security and Medicare tax, or FICA. If you do not pay yourself a salary, then you never pay FICA. FICA is 15.3% of whatever you pay yourself in compensation. As an S-Corporation shareholder, you have to pay yourself something that is deemed reasonable by the Internal Revenue Service. For instance, if you’re a doctor and your profits are $250,000, you would probably have to pay yourself a salary of about $175,000. The problem with reasonable compensation with an S-Corporation, is there’s no written rules. If you are examined by the Internal Revenue Service because of reasonable compensation, there is no set guidelines that the IRS goes by. The United States Tax Court, however, will use a litany of tests. One of these tests is what you would be paid, anywhere else, doing the same job. This is being challenged in court, because the courts will use public companies, because those company’s records are public. The argument against that, is that your company is not a multibillion-dollar corporation, so you wouldn’t be paying the same amount to the shareholders, or the executives, that a multibillion-dollar corporation would pay. There are several Tax Court cases that address reasonable compensation for S-Corporation shareholders.

On the other hand, C-Corporations are scrutinized for paying too much in compensation. C-Corporations pay tax at the federal level, if you take any money out of the C-Corporation you pay tax again on your personal tax return. When you take money out of the C-Corporation that is not a salary it is considered a dividend. Dividends are not deductible to the corporation. For instance, if you have a $75,000 profit the C-Corporation will pay tax at 25% on the $75,000. If you take that money out as a dividend, it will not lower the taxable effect of the $75,000. That is always been the downside to a C-Corporation. However, let’s do some math and I’m going to show you that being a C-Corporation is not such a bad idea.

Let’s say that you are an S-Corporation, and you’re in the 39.6% tax bracket. Let’s say you take a salary of $75,000, and the S-Corporation flows over another $75,000 to your personal tax return. The taxes you will pay on your salary will be $11,475 and FICA taxes, and $29,700 in income tax. The additional $75,000 that comes from the S-Corporation will be taxed at another $29,700. Your total taxes will be $70,875.

Let’s do the same exercise with a C-Corporation. Let’s say that the C-Corporation has a $75,000 profit. You will pay tax at the corporate level of $11,250. Let’s say you take $75,000 out as a salary. Your FICA taxes will be $11,475, and were going to presume that you’re still in the same 39.9% tax bracket, and your income tax would be $29,700. Now let’s say you took the $75,000 out as a dividend. Dividends are taxed at 15%, so your tax on $75,000 would be $11,250. Your total tax in this scenario would be $63,675. That is a total savings of $7200.

Not to mention that a C-Corporation can deduct fringe benefits like a medical reimbursement plan, health insurance, auto expenses, and other fringe benefits that an S-Corporation cannot deduct.

Maybe it’s time to revisit being a C-Corporation, even with the double taxation.

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