S-corp owners: What is "reasonable W2 salary"? What did you set yours?

[boglechu]

I am a solo doctor in California with 5 employees. I earned about $500k/year. I was told before that If I set my s2 salary around social security wage base, they wouldn't bother to audit me. However, I heard of friends who set a really low salary such as $80k/year to minimize payroll taxes. I also have friends who set their salary at $240k/year and take the rest as distributions.

"The current tax rate for social security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, or 2.9% total"

For 2016, social security wage base was $118,500 so I set my W2 income as $120,000. I deduct $18k for 401k. I also deduct about $4000 for health insurance.
For 2017, social security wage base was $127,200, so I set my W2 income as $128,500. I deduct $18k for 401k. I also deduct about $4000 for health insurance.

Trying to figure out what salary to set for 2018. Planning to set about $150k/year salary and the rest distributions of $350k.

My company does 401k match of 4%.

Don't know if I should set the 401k salary to get a greater match. If I increase my salary from $128,500 a year to $185,000 to 2018, I would pay $56,600 more in W2. From the $56,600, my company would match 4% of that or $2260. I would have to pay 1.45% of $56,600 or $820.70 and my company pays $820.70 for a total of $1641.40 in taxes for the additional $2260 in my 401k.

Just wanted to get your thoughts. It doesn't make sense to me to set a higher w2 income.

[Zaphod]

People always act like this is some massive savings, however since you have to pay all the payroll anyway you're really not saving yourself anything. Especially since youre in california and the FTB costs to start and maintain an S corp isnt worth the savings and increased complexity. You have to do the math.

You've effectively shortchanged yourself out of 36k more tax deferred retirement savings in either a 401k or TIRA. You can do much more with a cash balance plan.

I dont get your set up. Arent you the company? Who is doing the matching. Something sounds goofy.

[boglechu]

I’m he owner of the company so I am the one putting the match in through my s-corp

[boglechu]

Boglechu md inc is an scorp with $1 million in collections and $500k in expenses.

[HumbleInvestor]

Boglechu,

Your W2 salary should be similar to what you would pay some one to fill your role (say when you go on vacation etc). You will reduce your taxes by deferring more of your income in to your 401k. My wife is in a similar boat to you and was paying herself around $120. Now she is paying herself an additional bonus (gives flexibility to change structure in future if needed) to take her W2 wages to $270k (Max allowed for 401k contribution calcs). Yes you do pay extra Medicare taxes but you can also get higher deductible match ($10,800). But you would also need profit sharing component to get up to the full 401k contribution of 54K.  If your taxable income is lower than $500K (married filing), with the new senate proposal you can deduct 23% of your Taxable income or your W2 wages whichever is lower. If you only give yourself a W2 wage of $100K, you can only deduct $23000 instead of higher amounts if you can balance W2 wage vs Taxable Income percentages. Since each of these components impact your overall tax in varying ways, you would be wise to make those calculations or seek help from an accountant.

Good Luck.

HI.

[jfoxcpacfp]

Whoever told you that you just need to set your wage to = SS wage base was wrong. At least pay yourself an equal salary to distributions. To the best of my knowledge, the IRA has left s-corp owners alone at that calculation. However, as Zaphod and HumbleInvestor pointed out, you are leaving 401k dollars on the table.

[boglechu]

Setting minimum w2 salary near as base wage was recommendation I read on one website (forgot name) to avoid audit since you’ve already pay the 12.4% ss tax up to the base wage and the only amount left is the Medicare 2.9% tax. The blogger wrote that since irs got the 12.4%, they would be less inclined to chase after the 2.9% in an audit.

Suppose I set w2 as $270,000 rather than $128,500. Difference is $141,500. That’s $4,103.5 extra Medicare taxes that I pay.

For $141,500, 4% employee match on 401k is $5660.

Doesn’t make sense to try to maximum 401k

[Zaphod]

what the heck are you talking about with this employer match? why is it just 4%. it should max out at 54k this year, 18k, empliyee, 36k "employer". since you are both and this is a forum and not tax court you can drop the formalities as it's confusing.

It's only 4% because for some reason you chose that. Make it 200%, that's what my "employer" match is. that said, my employer is amazing and the absolute best.

[DMFA]

boglechu wrote:

Setting minimum w2 salary near as base wage was recommendation I read on one website (forgot name) to avoid audit since you’ve already pay the 12.4% ss tax up to the base wage and the only amount left is the Medicare 2.9% tax. The blogger wrote that since irs got the 12.4%, they would be less inclined to chase after the 2.9% in an audit.

Suppose I set w2 as $270,000 rather than $128,500. Difference is $141,500. That’s $4,103.5 extra Medicare taxes that I pay.

For $141,500, 4% employee match on 401k is $5660.

Doesn’t make sense to try to maximum 401k

Click to expand...

I beg your pardon, but I'm not certain you completely understand tax reduction or 401(k) contributions. Unless you have other employees for which the profit-sharing contributions would be cost-prohibitive, then the best tax break you're going to get is the $54,000 on your 401(k).

What is the thought process behind your decision? Let's troubleshoot this.

[boglechu]

I had set match to 4%.

My 5 employees make $30-45k each year. Salary for them about $170k total.

If i set it to be a 24% profit sharing component, I could get $128500 * 24% = $30840 + 5140 =35980.

However, it means I have to our 24% profit sharing to employees or $40,800.

[boglechu]

Currently I pay about $6800 a year to match employee 4% contributions for their salaries that total $170k

[jfoxcpacfp]

Ah, the fog clears. We're way off the original question you asked (sorry about that!) but I've already given my opinion (50:50 salary and distributions). You need to look into: 1) a pooled 401k plan and 2) a defined benefit plan.

Rex is correct that you should have documentation of "reasonable" salary but, for audit purposes, I don't believe you'll have to worry about 50:50. At least that ratio hasn't been thrown out yet.

[Zaphod]

Okay, now things are making more sense. I agree you can change the 401k plan type, you may be surprised that most people still wont pay in even if the match is amazing though.

[spiritrider]

As several people have pointed out, there is really no evidence that the IRS will be less likely audit you just because your W-2 wages >= the Social Security maximum wage base. The blog might have been saying this because if you are audited, the reclassification of distributions to compensation will require paying the FICA you didn't pay plus a 100% penalty of that amount. Obviously, 100% of 15.3% of the reclassification is a lot worse than 100% of 2.9%.

You are not unique from a lot of physicians who think unreasonably low salaries are OK. That might have been fine a long time ago, but this issue has been on the IRS' priority list for quite a while. Now the risks of an audit are still quite low. People think there is no guidance, because there isn't a simple formula. Well that is because each circumstance is different and there are a number of variables.

However, there have been a number of court cases over the past several years to narrow that variance. The two that come to mind are directly relevant to a private physician practice. Those two court cases found that the compensation should be 40% - 60% of net income. That is probably the basis of the 50:50 compensation:distribution ratio jfoxcpacfp was referring to.

However, Rex really has the correct answer. In both of these cases the courts used a comparative compensation study of someone with the knowledge, skills and experience in the local market of the S-Corp shareholder-employee as the primary factor in determining "reasonable compensation. Then they grossed that up to factor in management and administrative value. The IRS has consistent guidance and enforcement on reasonable compensation issues. They use the Risk Management Association (RMA) Annual Statement Studies on small and medium businesses to compare profitability (distributions) and various salary surveys (compensation).

Basically, your W-2 wages should be roughly the W-2 salary you would get employed elsewhere grossed up for being an owner. The additional profit leveraged from capital, equipment and staff services would be paid as distributions.