Reasonable Officer Compensation for S Corp Painting Businesses

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Hi, this is Daniel, the founder of Bookkeeping for Painters.

And this is Richard, the tax director for Bookkeeping for Painters.

How's it going, Richard?

It's going good, Daniel. How about yourself?

Doing well. It's a beautiful, beautiful morning over here in Nicaragua.

Awesome. Well, I'm glad you're having good weather because, you know, here in northern Illinois, winter is just barely holding on. And we had a little bit of a chilly morning, but we know we've got some sunshine hopefully coming up soon. But we didn't get together to talk about the weather this morning, did we? No. We're talking about money. Everyone, everyone loves to talk about money. Yeah. So, you know, our last episode we talked about how much you should be paying yourself as a percentage of revenue. And today we're going to talk about how you pay yourself, specifically how you pay yourself in an S corporation. Now, if you are a one-man show, you're a sole proprietor, or if you're a partnership where you have, you know, a couple of different owners, but you're still kind of, you know, disregarded as far as tax purposes goes, you know, you're used to taking owner draws from the business as needed. And that's good. That's how you should be paying yourself. Sole proprietorships, partnerships. So if you file on a Schedule C or if you file a 1065, you should not be on payroll. If you're an owner, you should not be on payroll. Everything comes to you as draws. But if you have elected S corp taxation, so you're filing a Form 1120-S, or if you have, you know, regular C corp taxation, Form 1120, then you are going to be required actually to have yourself on payroll, you're going to be required to pay yourself what is called reasonable compensation. And that is a reasonable amount as compensation for the work that you do in the business.

Yeah, this is something that a lot of folks, when I talk to them initially on this, they are like, yeah, I pay myself a reasonable salary. I just take 50% of whatever the profit was and pay that as a salary to myself.

Yeah, there's, it is so difficult to know what that number should be as reasonable salary. And a lot of people do use, you know, kind of a shortcut, 50% of revenue or 60% of revenue. But that's probably not gonna be in your best interest. And I'll tell you why. The thing with reasonable compensation and salary is that you've split yourself up into two categories. There is the you who is the employee of the business, the you who is, you know, selling the jobs, doing the jobs, running the admin, and you're performing these services for the business. You need to be paid as an employee for the work that you do. But then there's also the you who's the investor. You've put up the money to start this business. You've put in the work to get it off the ground. And the compensation you get for being an investor is going to be different than the compensation you get as being an employee, because the employee compensation, that's subject to payroll tax. But the investor compensation, that is not subject to payroll tax. And that's how we really, you know, split you into those two categories to help significantly reduce the amount of taxes you're paying, because otherwise you'd be paying 15.3% self-employment tax on everything you earn.

Yeah. And, and I know we had talked about in a previous episode if you're not an S corp yet, just throw this in here real quick. The— if you're not an S corp yet, taxed as an S corp, I should say, and your profit, your bottom line profit is $50,000 or $60,000 or higher, you probably should look at electing to be taxed as an S corp because of what you had just said, which is all your earnings are getting taxed at that 15.3%.

Yeah, absolutely. You know, if you're making $60,000 a year and you're paying that 15.3% self-employment tax on the entire 60, wouldn't it be great if you could kind of split that up and pay yourself a portion of that as wages, which you'll still have to pay the tax on, but then whatever above and beyond that would come to you without that payroll tax. So, you know, the natural question then is, how much do I pay myself in wages? And we want to be, you know, very careful about how we do this. We really, really want to dial this in, you know, exactly as much as we need to. And the reason is, is we don't want to pay any more payroll tax than we absolutely have to. For every $1,000 that you pay yourself in payroll, you're paying about $150 in taxes. So if you can reduce your payroll even by a few thousand dollars a year, that's going to add up to significant savings.

Well, why don't you just not pay yourself a payroll? Don't put yourself on payroll and you'll save all those payroll taxes.

That sounds like the one trick the IRS doesn't want you to know. Right, right. Exactly right. Yeah, sure. I'll pay myself a dollar. Dollar's good, right? So the IRS knows that trick, unfortunately. And that's where the reasonable part of reasonable compensation comes in. It has to be appropriate for what you do. And what would happen if it's not? Well, then the IRS does have the right to examine you and reclassify your tax-free distributions as payroll and also assess back payroll taxes and penalties and interest and all sorts of unpleasant things for prior years. So we can't, we can't go too low. And put ourselves in the crosshairs of the IRS. We don't want to go too high and pay unnecessary payroll tax. So how do we, how do we dial it in? Well, first of all, let me, let me kind of COVID a few of the ways people have been determining reasonable compensation in the past. And then I'm going to tell you why I don't like those ideas. One way is a percentage of revenue. 50%, 60% of revenue, I'll pay myself as profit. Well, that, that number can vary a lot depending on how well the business is doing, and it may or may not be appropriate. The way to figure out your reasonable compensation is to think about what would it cost you if you had to hire somebody else to do the work that you do in the business. And that amount is going to vary depending on exactly what you do, where you live, and what prevailing wages are. You know, you can imagine that hiring an admin in New York City is going to be a lot more expensive than hiring an admin in, you know, rural Texas, for example. And it's also going to depend on the type of work you do. You know, you're gonna pay an office worker less than you're going to pay a journeyman painter. And so we want to kind of break up the different tasks that you do, assign them a dollar amount that is appropriate for the task, appropriate for where you live, and come up with a really dialed-in salary recommendation. Now, for our tax planning clients, we use a third-party software that gathers data from the Department of Labor and the Census Bureau and knows exactly what the prevailing wages are for thousands of different types of jobs in hundreds of different counties throughout the country. And we put together a very comprehensive report for our clients because it is, in my opinion, the best way to make sure that they are not overpaying themselves, but also gives them a rock-solid basis for setting their salary that would be defensible if it was to ever be examined. These reports have—

yeah, I was going to say, and if you look at the tax case law, for when the IRS challenges a taxpayer on their reasonable salary that they paid them themselves in their S corp, they use the same method. Basically, they look at the salary data in your area. What do you do in your business? And they, they put together, hey, based off of what you do, what other folks get paid for that same work. You should have paid yourself this wage. And so when the IRS challenges taxpayers on this topic, they use the same method. So we're basically using the same method that the IRS uses to prosecute people, but we're using it to protect you and to pay you no more than what you should be paid, instead of using like the general rules of thumb, like 50% of profit goes to you as a payroll salary or whatever.

Yeah, absolutely. These reports have stood up in tax court. There's kind of an expression, you know, in the legal world. I'm not a lawyer, obviously, but they talk about whoever brings the data first wins. So if the IRS is saying that, you know, your salary is not appropriate for what you do and you present a report with hard data and hard numbers showing why you chose that number, that's going to prevail over anyone's opinion, anyone's feelings. And so I love having the security of that report. Now these, you know, what if these reports are not available to you? Because frankly, they are expensive and they're not always easy to come by. What could you do if you don't have one of these reports? Well, my advice is Go look at want ads, maybe on indeed.com or monster.com, and figure out what people in your area are paying to hire people who do the jobs you do. So if you are, you know, running the business as an operations manager, look for want ads that are offering a salary to, you know, operations managers for similar companies. Is this as good as a comprehensive report? No, but it will give you a methodology and it will give you, you know, some kind of a basis for starting out.

Yeah. And when you're looking at the different salary, if you go to Glassdoor or whatever you're looking at, also try to, like you had said earlier, Put together a list of things that you do, what are your main roles in your business, and then assign a percentage of your time that you spend in each role. So if you're the production manager, the salesperson, the admin person, and you do 30% in sales, 40% in production management, and then the rest of the time as an admin or whatever, you could look up each of those roles on whatever dataset you're looking through, Glassdoor or Indeed, and then look at what the salary is for each of those and multiply it by that percentage that you, you spend in that role for the year to get, and then add those all together to get your reasonable salary. So that would be a good methodology to kind of have a, a good basis to defend yourself if you were ever challenged on your officer salary.

Yeah, absolutely. Because you are wearing many hats and what you pay a sales manager should not be the same amount you pay an admin person. And that includes paying yourself. Now, we talked about, you know, wanting to hit certain, you know, profit or take-home profit goals for yourself. And that's, that's going to involve your overall compensation. So we want to get your, your salary as low as we can reasonably justify. And then the rest of the money that you need to take for yourself, that's going to come in the form of distributions. And sometimes we call these tax-free distributions. And I just want to clarify, these are payroll tax-free distributions. However, regular income tax will always be assessed on any, any profits that you make. So we get rid of 15%, but we can't get rid of all of it, unfortunately. So these distributions can be made to you from your company as you see fit. I recommend that there be some kind of like you know, more formal distribution. So for example, you might look at your financials and say there's an extra $10,000, I'm going to distribute that to myself on this date, because really what you're doing is you're, is you're distributing it to the shareholders on this date. If you're the only shareholder, you get all of it. If you have multiple shareholders, then you're going to distribute it according to the percentage of the company that they own. And that's very important if you're an S corp because S corps have to have common stock. They're not allowed to have preferred stock. And that just means that everyone has to be treated equally. If you have 3 shareholders and they all own a third of the company and they all get a third of the distribution, You can't give one shareholder 80%, another one 20%, and another one zero. That would be viewed as having different classes of shareholders, different classes of stock, and you could put your S corp election in jeopardy. Now, if you need something more complex like that, there are other types of taxation available. There's, there's C corp. You can also do something like this with a general partnership. But you're going to lose some of the tax benefits of an S corp. So just kind of keep that in mind. Everyone gets treated equally in an S corp. The other thing to keep in mind is that when you're taking these distributions, you don't want to over-distribute money either. So without getting too technical, you have the money you invested in the company. And you have the profit of the company that's been allocated to you, but you might have more cash in your company than just the investment and the profit. This is pretty common when, when business owners get loans. So SBA loans, EIDL loans can infuse a lot of cash into the company and it can be tempting to take some of that cash out for yourself. But if you distribute more to yourself than you have basis, and by basis we mean what you've contributed and the profit that's been allocated to you, then we have what's called distributions in excess of basis. And the IRS views that as basically you sold some of your company stock in order to get cash, and they will assess capital gains tax on, on you for that. The exact amount of the capital gains could be, you know, 15 or 20% if it's short term. If you've only owned the company for less than a year, it could be your ordinary tax rate. But, you know, and sometimes, you know, sometimes we do what we have to do. But if we can avoid this extra capital gains tax, we're going to want to do that.

Yeah, and I know a lot of folks that are taxed as S-corps, that is something that they often ask about, like, am I taking too much out of the business? And basis is, you know, if you sit down and study it, you can definitely grasp it and it makes sense, but it's kind of a, it's a calculation that continually updates and changes. It's not like you have a set basis and then you just It's always changing. So you definitely need to have an accountant that's on top of your basis so you know for sure exactly how much basis you have, so you know how much you can take out of your business. But if, if you either— as a shorthand way to determine how much you can take out of your business at any point in time during the year, if you don't have access to your accountant or, you know, you don't feel like going through the basis calculation. As a shorthand, you can look at your cash basis profit and loss bottom line net profit. So bottom line net profit on a cash basis profit and loss, look at that amount and then look at what you've taken out of the business so far. And as long as you haven't exceeded what your cash basis profit net profit is, you, you have you can, you can take up to that net profit amount during the year approximately because— and I say approximately because your cash basis profit, uh, profit and loss is not an exact mirror of what your tax return is going to look like, but it is a close— it's going to look pretty close to that assuming your books are being kept correctly. So that you can use that as a gauge to see, can I take out any money? Look at your net profit on your cash basis profit and loss, see what you've taken out so far this year to determine, okay, I can't exceed what my net profit is in distributions. That's my cap. So that should give you how much you can approximately— how much you should take out, you can take out without getting hit with those capital gains taxes that you mentioned.

Yeah. And the IRS says it is each shareholder's responsibility to know and maintain a basis calculation. And if you have a good tax professional, they're going to do those calculations for you. Basis is definitely something that I track and go over with my tax clients each year. And the IRS is actually becoming more strict about it. A few years ago, they released a new form. It's called 7203, and it's a report of each shareholder's basis to the IRS. So you might think, well, if I take out more money than I put in, how will the IRS know? They are cracking down on the reporting. So definitely, definitely know— I mean, know your equity, know what you have and what you can take out, especially, especially if you have more than one partner or more than one shareholder. You're going to want to have very good detailed records of who gets what, because someday you're going to want to sell the company or someday you're going to want to retire. And when that day comes for you to cash out, you need to know how much cash you have to take out. And your partners are going to want to know that you're only taking your fair share. So that's something that can kind of be overlooked in the beginning, but it's So much easier to track that right from the get-go. And a good bookkeeping system and a good tax professional will help you do that.

Absolutely. So I think we can go ahead and wrap this episode up. I'd love to hear what, what calculation you all are using to determine your reasonable officer salary. See, see what methods other folks are using. And see if this is helpful as well. And if you have any other ideas on future podcast episodes.

Yeah, absolutely. Let us know. You can join our Facebook group. It is called— what's our Facebook group called?

It's Grow Your Painting Business. Grow Your Painting Business on Facebook.

Grow Your Painting Business on Facebook.

Thank you.

Um, this is what happens when you have everything saved as links and you don't have to type anything in. You forget your own phone number, right?

Right. No idea what mine is.

Yeah, right, exactly. Uh, but yeah, Grow Your Penny Business, please, please join us. If you can remember the name, you're doing better than I am. And let us know in the comments, uh, how you figure your officer salary. Let us know if you think it's appropriate. I will just, you know, spoiler alert, I have met with a lot of business owners who think their salary is very, very appropriate. And it turns out they're actually paying themselves $20,000 or $30,000 more than they need to. And that is such a welcome surprise when they realize they're going to be able to save, you know, a few thousand dollars each year in payroll tax. So, yeah, let us know. Let us know how you handle it. And if you have any questions, let us know in the comments. That'd be awesome.

All right, and we'll talk to you next week.

Yeah, thanks for listening.