Follow-up question on S-Corporations and salaries

Sunday June 18, 2006

Today's tax question comes from M. Ryan in Florida, who is starting his own business and is asking a follow-up question to my post on S-Corporations paying salaries to owners. He asks:

"Hi William. I appreciate all of the information you provide here and I have a question regarding S-Corporations, payroll taxes, and reasonable compensation.

I am starting a business and am considering using the S corp form. I plan to eventually take my hands off of almost all operations to focus on other business pursuits and hire a manager to run the business for me.

In this situation, could I reasonably reduce my salary (and subsequently my self-employment taxes) when I leave the day-to-day operations of the business after two or three years? If so, what should I consider in this reduction? Thanks for your time."

Dear Mr. Ryan,

As I mentioned the other day, S-Corporations must pay owner-employees a reasonable salary.

Your plan of starting the business, and then handing over day-to-day management responsibilities to a non-shareholder makes complete sense. In fact, this is an ideal solution to the dilemma of the reasonable compensation rules. The S-Corporation should still pay you at least some salary, perhaps a small wage for time spent reviewing the corporation's performance, conducting the annual meeting, and attending to legal and financial matters. Since you will be working for the S-Corporation for a couple of years, the corporation will still need to pay you a reasonable level of salary based on your skills and experience. After you start working part-time, you could then convert your salary to an hourly rate, and then pay yourself based on the number of hours you actually work.

The nice thing about your business plan, is you are already planning ahead for having employees, including the necessary expense for payroll taxes. This is one area where I see a lot of entrepreneurs failing to plan ahead, so it's good hear you are already taking this into consideration.

More information:

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