Joe, a reader of this column, founded a family business, Success, Inc., that he headed for 24 years. His son, Bill, has been running the business for about six years.
He’s doing a good job too. Joe, age 64, has cut back his work time to three to four hours a day for nine months of the year. The other three months are spent in a warm climate (mostly Florida) or traveling.
As Success grew over the years, Joe took only enough salary to maintain his family’s lifestyle. Simple put, profits were not taken out of Success, but reinvested. The business is still profitable, and it’s Joe’s only source of income. Success is a C corporation (tax paying).
In the past, Joe had taken a rather modest salary during the year, but he took a big bonus (when profits were available) to fund large family cash requirements (college, vacations, condo, etc.). His professionals had advised him to continue this compensation practice — the same salary and bonus arrangement — even though Joe was putting in about one-third of the time of prior years. Joe called me to get a second opinion.
The IRS would probably attack Joe’s current compensation arrangement on two fronts: First, the bonus would be regarded as a dividend, because it’s not taken until after the end of the year when the amount of the profit could be determined; and second, the salary would be regarded as unreasonable (too high) compensation.
Would the IRS win? On the first attack, Joe and the business wouldn’t stand a chance. The IRS would win hands down with the result being a nondeductible dividend for Success, and a taxable dividend for Joe. Second, the IRS could probably knock out about half of Joe’s current salary as being too high for services actually rendered. Unfortunately the (unreasonable) salary issue is tough to pin down (when challenged by the IRS) with any certainty.
What should Joe do? He needs the current income to live. The answer is to kill the C corporation and elect S corporation status. This would automatically remove the unreasonable compensation problem. What about the bonus? As an S corporation, Joe could take a tax-free dividend from Success (up to the amount of S corporation profits). This means that Success’ profits would only be taxed once when taken as an S corporation dividend, instead of twice, when taken from a C corporation as a dividend. A big tax saving! Better yet, the same trick will continue to work when Joe completely retires (take those delightful tax-free dividends).
One more thing: S corporation dividends (the economic equivalent of a bonus to Joe) are not subject to Social Security tax or other payroll taxes … another big tax saving. And here’s an extra bonus: Joe can collect Social Security benefits even if he continues to work for Success.
If you’re not tuned into the many advantages of electing S corporation status, you owe it to yourself to get the true tax facts. So, to be or not to be an S corporation? That is the question.
In practice, many factors can impact your decision. Still have doubts? Call Irv (417-9732) and I’ll walk you through to the right C or S decision.
