Resetting Base Salary

[brm98072]

I have an S-Corp with two other principles. We are a Software VAR and are starting to develop some of our own software for sale to businesses. We bootstrapped the business and have no additional employees.

We originally set base salary at $100k per year. In looking back, we believe we set salaries too high. We are carrying the back salaries as a liability. This is our second year in business and we expect to make about $50k this year.

We know a lot more about running a business now, so I am exploring lowering our base salaries to $75K per year, which we believe is more reflective of the market and would be acceptable as a base salary in the eyes of the government. We also aren't sure if we need to carry the unpaid back salary at 100k if we lower our base.

Any thoughts on lowering base salary going forward and reducing our back pay liability would be appreciated. I plan to talk with an accountant who is very familiar with S-Corps, but like to have background before I do that.

Thanks,
Brian

[Business Attorney]

Lowering your salary sounds like the right action under the circumstances you described. Besides, it is usually a good idea in an S corporation to pay only a "reasonable" salary to the owners and distribute the rest of the profit as dividends. It saves on payroll taxes. Talk to your accountant about it.

[jamesray50]

I don't do income taxes, but are you saying that you accrued your salaries for last year and haven't paid yourself yet so they are still owed to you, which is why they are a liability? And if you did that, then you also accrued the payroll taxes? Adjusting your base salary for this year will not effect the payroll tax liability you already owe for the salary you accrued last year. Does this make any sense? You can still change your base salary this year, but if you have already filed your tax return for 2010, then you can't adjust your salary for last year without filing an amended return. But, like I said, I don't do tax returns, only bookkeeping, so maybe someone else can chime in here.

[Evan]

I agree with the suggestion of David. Only pay what is reasonable, with the excess as dividends/distributions (based on your pro-rated share of ownership). Just remember, in an S-Corp, distributions are required to be equal based on the number of shares. So if you have 100 shares, and I own 30 and you own 30, you cannot take a $10K distribution and not give me anything. Doing this will actually probably result in revocation of your "S" election, and you'll revert to a C-Corp, so be careful.

Similarly stated by Jo Ellen -- I'm a bit uncertain with what you mean your "backpay liability". Did you receive a W-2 for this income or not? Was the payroll expense taken on the business return, and payroll taxes paid? This is a tough one to undo, and it is probably better to just have it paid out and move forward

[brm98072]

Thanks for all the response.

We will consult an S-Corp specialist accountant for advice on "reasonable" salaries.

Also to clarify, we have been carrying the unpaid portion of our $100k bases as a payroll liability. Of course, we only paid payroll taxes on the portion actually paid to us. We only created W-2's for the actual amount paid, less than half of the $100k.

Thanks,
Brian

[Evan]

Hmm, OK. So was the remaining $100K deducted as an expense on the tax return? Something doesn't make sense...

[brm98072]

Sorry for the confusion. On my tax returns, I only reported the amount we actually paid to the founders. I am carrying the accrued payroll as a liability on my balance sheet. My question is can I just lower the accrued payroll liability to clean up my books and reflect the $75K salaries we are going to assign ourselves.

[Evan]

If it was accrued on the balance sheet, the offsetting entry was deducting it as an expense. Otherwise, what was the other side of this entry?

[brm98072]

I have journal entries for each pay period as:

CREDIT: Payroll Liabilities:Accrue Salaries Payable
DEBIT: 3 entries (one for each founder) of Payroll Expenses:Salaries Expense

[Evan]

Exactly -- so this was deducted in prior years as an expense.