The traditional thought is that tax savings in S Corporations are realized through taking reasonable compensation as wages, and additional money withdrawn as distributions. Distributions are not subject to payroll taxes. In many cases this makes sense, and is an appropriate strategy. But not always. Below is a list of reasons to avoid distributions, and paying the extra payroll taxes might be worth it.
Loans & Mortgages
Unfortunately lenders consider the W-2 as the gold standard when extending credit. They should consider multiple items when evaluating credit worthiness of a client with a pass-through entity—wages, distributions, loan activity, contributions, and 401k/profit sharing activity. Unfortunately, lenders are not savvy enough to understand the complete picture, and often discount or ignore the K-1 activity. Considering this activity is necessary in an analysis of cash flow from the S Corporation to the Shareholder. If the shareholder wants maximum buying power at minimum rates, the W-2 is the hassle-free answer.
California Income Tax
California imposes a 1.5% tax on S Corporation net income. In a case where the shareholder is exceeding the FICA cap on wages of $118,500, distributions only save 1.4% on payroll taxes (the combined Medicare tax of 2.9% less California income tax of 1.5%). Yes the shareholder may be subject to the additional .9% Medicare tax. However as a percentage, distributions saving on payroll taxes is not as high as many presume.
Research & Development Credit
In a case where the Owner is performing Research and Development, his wages may be considered qualified expenses for the R&D credit. Distributions are not eligible. With high wages, this credit can be significant (however is often subject to the General Business Credit Limitations, especially AMT). The credit does carry forward, and through careful planning, it can often be worth paying additional taxes to secure.
Defined Benefit Plan Benefit Limitations
For Clients who have a Defined Benefit Plan or dual plans, contributions are limited based upon compensation amounts. Contributions cannot exceed 100% of wages, and with a contribution limit for a dual plan being up to $265,000, high wages are needed to reach the maximum contribution. Also in profit sharing allocations, the Annual Compensation Limit of up to $265,000 is used, allocating more to Ownership. These scenarios often arise in the Professional Services field.
Wages vs. Distribution is a hot topic for debate. Guidance on this topic varies widely, from exact ratios to circumstantial calculations. IRS opinion of reasonable compensation likely varies from agent to agent. Maximizing wages removes this as an issue in the event of an exam.
Above are some items to consider when determining shareholder wages. There is no one-size-fits-all solution. However in certain cases, high wages make sense, and the practitioner should discuss these considerations with the client.