The weird world of wages in S Corps

Brian Hufford, CPA, CFP®

For more on this topic, go to www.dentaleconomics.com and search using the following key words: S Corporations, payroll taxes, nontaxable distributions, audit, Brian Hufford.

My experience tells me that about half of dentists practice as S Corporations. If true, this means that S Corporations are the most popular entity for dental practices. Why are S Corps so popular? Two reasons: limited legal liability, and the weird world of wages in S Corporations.

Since other forms of entity provide liability protection, I assume that S Corporation status is primarily chosen for savings in payroll taxes, thus the weird world of wages distinction. This column will explore this strange geography and note the pitfalls of wage planning in S Corporations.

Suppose a dentist has a highly profitable practice with 2011 net profits of $500,000. If the dentist practices as a sole proprietorship, the self-employment taxes (FICA and Medicare tax) would be estimated at $24,498. This is in addition to income taxes owed.

If this same dentist practiced in an S Corporation and paid zero wages, but instead distributed the profits as nontaxable distributions, the dentist would pay zero payroll taxes. What a weird world! Why wouldn’t every dentist inhabit this fair land? Doesn’t some tax law, a sort of tax-savings Berlin Wall, prohibit this simple escape from payroll taxes?

Strangely, neither the Internal Revenue Code nor Treasury regulations have specific guidelines for wages in S Corps. The regulations only provide that compensation paid to the dentist must be reasonable for like services by like enterprises under like circumstances. This means that zero wages in the service of dentistry will likely be declared unreasonable upon an IRS audit. But what is reasonable? Would $25,000 in wages be reasonable for this example? This low-wage amount would still save a large amount of payroll taxes.

Several months ago, the Government Accounting Office released a report concluding that an estimated $23.6 billion of underpaid wages existed in S Corporations (what a weird world, dentists underpaying themselves). In May 2010, the House passed the American Jobs, Closing Tax Loopholes, and Preventing Outsourcing Act of 2010, proposing the closing of the payroll tax loophole for dentists who practice as S Corporations. This bill didn’t pass the Senate; thus the loophole still exists. It is not likely to be closed in the foreseeable future. But, due to the GAO report, it is likely the IRS will target S Corporation compensation in future audits. So how should you plan compensation?

I have found that dentists pursue two basic strategies with wages in S Corporations. The first strategy is to exploit the loophole and pay extremely low wages to avoid a substantial amount of Social Security and Medicare taxes. These dentists live on the edge of what is “reasonable compensation.” This exploitation, while risky in an IRS audit, still leaves room for an aggressive stance since what is reasonable is a subjective decision, and court cases have not been conclusive.

To increase the likelihood of surviving an IRS audit with this aggressive stance, it is important to document in corporate minutes and other records why the compensation is reasonable. Most dentists don’t do this important step. Dentists who pursue this aggressive tax-savings strategy typically save for retirement using a SIMPLE-IRA strategy because wages are low.

The second strategy dentists use in S Corporations is to ignore the weird world of wages and pay a high salary, even though resulting payroll taxes are large, in order to fully fund a 401(k) or other qualified retirement plan to save income taxes. The reason for paying this high salary is that most retirement plans are based upon a percentage of payroll. If your retirement plan states that income tax-deductible contributions are 25% of payroll and your S Corp wages are only $40,000 instead of $150,000, then you have greatly limited the ability to achieve income tax savings and retirement goals by attempting to save payroll taxes with a low wage.

While I typically prefer a higher-wage strategy because I want dentists to save aggressively, it does present other problems. By paying a high wage and funding large deductible retirement contributions, the dentist can eliminate nearly all taxable income in the S Corp, leaving him or her to pay taxes on wages only. This is good; however, the absence of S Corp income can create problems with other deductions, particularly equipment deductions in which another weird world exists: that of S Corp shareholder basis.

If you are in an S Corporation, you should have an accountant assure that you have fully explored the unexpected outcomes of payroll tax savings vs. retirement planning vs. children’s payroll taxes vs. equipment and office real estate deductions. Don’t let the siren’s call of payroll tax savings distract you from other negative, unintended consequences that can exist in the weird world of S Corporations.

IRS Circular 230 Notice: This communication and any federal tax advice contained herein is not intended to be used, and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer or to promote, market or recommend to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].