My wife and I built an on-line business which is run by a manager we hired and 5 employees. Initially it was Schedule C which we converted to an LLC taxed as an S-corp in 2010. This was about 3 years after starting the business. We tried to come up with a reasonable salary for each of us. I based it on my Software Dev salary and the amount of time we spent working (20hrs/week). We gave ourselves a salary of 35k, and 40k/yr. This wage has continued and has amounted to 25% of our total profit from the business. The remaining profit was taken as dividends at random times sometimes more than once a month.
Since 2010 our involvement in the business has declined significantly. My wife started another business that she has spent nearly all of her time on since 2012. I've had more involvement with the business but would guess it is probably less than 10% of my time. I was trying to build other businesses as well.
We were told by the IRS we're not paying enough wages to ourselves (social security/Medicare), and that we need to convert 200k of dividends from 2013/14 to wages. This amounts to 21k of tax and 4k of fees. They want to charge so much to "make up" for 2010-2012.
the IRS stated this because the ration of dividends to salary is too high. Salary versus dividends are relative to one another. If it appears to the IRS that someone declared more income as dividend income to avoid tax liability, they will re-categorize a portion of the dividends as income or require you to do so. However, you can negotiate this with them
S corporation working shareholders must take reasonable salaries“based on facts and circumstances”. There is no fixed formula, you need to use; 1) what you would have paid to hire some else instead, 2) industry averages, 4) what others would have paid you to do the same for them, etc. I know many CPAs are very skilled in this area. The information presented herein is for general purposes only. It is not intended to, and may not be construed as legal, tax or accounting advice or solicitation. For specific advice, please consult a suitable attorney in person. Good luck. Zaher Fallahi, Business and Tax Attorney, CPA, MBA, MS.
The amount of reasonable compensation is a factual issue.
You should retain a tax attorney to represent you. The attorney may want to hire an expert who would prepare a report to indicate what the amount of the reasonable compensation should be.
This is an issue that should be able to be settled if you attorney is able to provide persuasive evidence to support your position.
In the Utah area, a developer usually makes a lot more than 35-40K per year. Like the other attorneys have said, this is a facts and circumstances test. But 25% of your take-home pay allocated to salary is likely too little. A more appropriate ratio is about 40-80% of your total take home pay allocated to salary with 40% being more risky. Look at the factors that the other attorney posted and contact a Salt Lake attorney if you want to dispute this. If this is still in the audit/examination side of things, it is worth disputing.
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