Subchapter S compensation – trap for the unwary

As we hit the half way mark for 2012, many insurance agents are probably trying to determine what the rest of the year will bring in terms of compensation and how to minimize the taxes paid on that compensation.  For those who are owners of Subchapter S corporations, there is one relatively easy way to reduce the amount of taxes paid on a portion of their compensation.  While FICA (social security and medicare) taxes are owed on all salary paid to such an owner, no such taxes are paid on distributions of profit taken by the owner. 

Thus, an owner of a Subchapter S corporation can save the 15.3% FICA tax on each dollar that he or she takes as a distribution of profit.  That is a significant savings, which has lead some Subchapter S owners to pay themselves a very modest salary and take most of their compensation as profit distributions.  Unfortunately, such owners have ended up in trouble with the IRS, because the law requires them to pay themselves “reasonable compensation” in the form of salary.  What is “reasonable compensation” will depend on what other persons in the local area performing services similar to those performed by the owner are being paid.  

In one recent example, an accountant paid himself $24,000 in salary and over $200,000 in profit distribution in one year.  Such a large disparity is a red flag for the IRS and the accountant ended up owing a significant amount of back taxes, plus penalties and interest, to the IRS.  So those of you who are owners of a Subchapter S corporation need to be wary about the amount of profit distributions that you pay yourselves throughout the year, or you may experience an unwelcome visit from the IRS.