Tacoma, WA asked in Tax Law and Business Law for Washington

Q: For a single-person LLC choosing to be taxed as an S-Corp, what if revenue isn't enough to pay a "reasonable salary?"

I understand salary must be "reasonable in industry standards" but who decides that, and what if there simply isn't enough revenue to sustain a "reasonable" salary for the owner? I'm a sole prop now (just me, pretty small income), and I'm trying to study the pros/cons of moving to LLC-taxed-like-sole-prop, vs LLC-taxed-like-scorp....a lot of sites warn me about the "salary vs dividends" thing but I can't find out what happens of the company just is low on cash and cannot pay that salary. Where can I learn more? Similarly,

is there a ballpark range/threshold as to what kind of revenue we're talking for this s-Corp tax option to be "worth the savings" that this would provide? (I'm talking income less than 50k). I hope that all makes sense.

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1 Lawyer Answer
Matthew M Montoya
Matthew M Montoya
  • Tax Law Lawyer
  • Lone Tree, CO

A: To put things in perspective, it's important to remember that an S-Corporation is its own legal person, separate and distinct from its owners. When you, as a single person, elect to turn your LLC into an S-Corporation, you automatically wear two hats - that of a business owner and that of an employee (officer of the corporation). You have to treat yourself (in your employee capacity) as you would any other employee, or the whole thing falls apart. This means that there's the risk that the IRS would be able to disregard the S-Corporation and hit you with the full self-employment tax you would ordinarily have saved, plus penalties and interest.

To get back to your questions - the industry standard is just that. There can be a wide range of "reasonable" but "reasonable" is frustratingly vague. Lots of factors can come into play, including net revenue. You'll have to do some research to see what your industry would be willing to pay if they hired someone to do your job. If you can't pay a salary, you're sailing into dangerous territory since you're asking an employee (who happens to be yourself) to perform services for no pay. This creates many different unwelcome risks.

Realistically, if you're considering an S-Corporation, it can be dangerous to try it on your own. You will need several professionals to help you - a business attorney for the proper contracts and employment agreements (yes, you must formally employ yourself), an accountant or CPA to help with the ongoing compliance requirements, and a tax attorney advising the business attorney (and the CPA) to make sure the S-Corp is properly structured tax-wise. In fact, in December of last year, there was a Tax Court case where an S-Corp was disregarded by the IRS and the business had a CPA and a business attorney. If that sounds daunting, then an S-Corp may not be right for you. You need to calculate the cost of doing things properly against your potential savings.

Of course, there are other advantages to an S-Corp other than the self-employment tax, but that'd be another whole answer.

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