This is an update to an article I wrote previously entitled, “Increase your take-home pay by paying yourself less” dealing with mixing payroll and dividends to reduce personal tax liability for S-Corp owners. That previous article left one question unanswered (as does the Tax Code): If I am mixing payroll and dividends, what’s the right mix? The tax code requires only that the total compensation paid out to an S-Corp owner include a “reasonable” amount of regular W-2 wages. This doesn’t help at all because it does not define “reasonable.” Often a rule of thumb is “take half as wages, and the other half as dividends.” Isn’t there something a bit more precise than that? A recent tax court case has provided valuable guidance on this question by relying on IRS Fact Sheet 2008-25.

IRS Fact Sheet 2008-25 provides several factors to consider when setting your salary level. These include your training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, timing and manner of paying bonuses to other key people, what comparable businesses pay their people and whether a formula was used to set compensation.

We can develop a general principle from the guidelines. If you wanted to quit working, live off the profits of the business, and hire someone to do your job, what would you have to pay them to do it? This simple test wraps into it most of the factors that the courts review in cases such as these. It requires you to consider how many hours you work, your skill level, your experience, and so on. The result would be a reasonable salary based upon real-world data and factors. Also, as would be the case if you were a fully passive shareholder, pay dividends quarterly or annually and not on the same schedule payroll is cut.

The court case in question dealt with an accounting firm that paid its partners nothing in salary. Instead, each partner formed their own personal S-Corporation and would provide services to the accounting firm through that S-Corporation. Instead of paying the partners directly, the accounting firm paid their respective S-Corporations. Then the partner would take compensation from his personal S-Corporation. Some was taken as payroll, some as a dividend just as described above. This arrangement created no problems.

The problem arose when the court reviewed the mix of payroll and dividends at the personal S-Corp level. The partner in question paid himself $24,000 in payroll from his personal S-Corp, but then took $240,000 in dividends. The court reviewed the type of work the partner was doing, the amount of time he spent working, his level of expertise, and the going rate of other accountants of similar skill and stature and very easily concluded that $24,000 was a ridiculously low salary. Using the test I recommend, that partner could never have found another accountant to work in his place for $24,000.

This accountant took a good concept and stretched it too far. He made the very common mistake of pushing so hard that he went from tax avoidance to tax evasion. The key is being aggressive about your tax structure, but keeping your strategic moves honest and reasonable.