One of the most basic planning questions for S-Corp owners is the allocation of earnings between salary and K-1 income. Before getting into the W-2 vs K-1 issues we’ll point out that the owner of an S-Corp is a statutory employee and as such is supposed to receive a salary.
Early on in the S-Corp’s life there is typically some ability to limit the amount of W-2 salary while leaving some of the earnings to flow to the owner in the form of K-1 income. To the extent the income is allocated to the K-1 the owner avoids FICA tax which counting the employer and employee portion is approximately 15%. That can be a nice savings when the business owner is starting things up. However, it should be noted that this allocation of income has to be reasonable. There will need to be some correlation between the job duties being performed by the owner and the salary.
For example an attorney who earns $100,000 in a year will have a hard time justifying a $10,000 salary while allowing $90,000 to flow to the K-1. While the owner of a restaurant who spends a significant portion of his time tending bar could much more easily justify a $30,000 salary while allowing $70,000 to flow to the K-1. A good question to ask is what would it cost to replace the job function being assumed by the owner?
As the business matures overall earnings typically increase. Let’s say income increases from $100,000 to say $400,000. In this scenario the owner needs to consider a pension or 401k plan. His employees may be demanding it. Once a pension plan is in place the owner has the opportunity to shelter income by contributing to the plan. To maximize this benefit the S-Corp owner will want a much larger portion of overall income to be paid in the form of salary.
It’s at this point a CPA can help. We can help determine when an owner’s salary is reasonable and how to maximize the contribution that can be made to a pension plan. If you’re an S-Corp owner who has questions about these issue give us a call.