When writing the title of this post, I was reminded of the term “subway series” relative to baseball games (remember when they used to play those?) between the rival New York Mets and New York Yankees. It could also apply to the Chicago Cubs and Chicago White Sox. The series of posts I am beginning, however, has nothing to do with baseball but everything to do with corporations and LLCs that have elected to be taxed as Sub-S entities.
Through webinars and interviews relative to the interest in PPP loans and EIDL loans, I have become aware of an interesting fact. There are a lot of entrepreneurs in the real estate space who do not know or understand the correct rules governing the formation and operation of Sub-S entities. I want to address this problem, beginning with the biggest and thorniest issue of all.
The owners of a Sub-S entity that work in the business must, repeat, must, pay themselves a reasonable salary. In the last several weeks, I have encountered dozens of owners and operators who have candidly admitted, “Jeff, I don’t pay myself a salary. What should I be doing?” After biting back the words, “Fire your accountant or tax preparer!”, I generally force myself to smile and say, “You should know that you are required by law to pay yourself a reasonable salary since you are an owner who is working inside the Sub-S entity, and the salary needs to be based upon the actual work you are doing.”
Like any good lawyer or real estate investor, when a person hears the word “reasonable”, he or she thinks there is some sort of “negotiable flexibility”, and there is; but it must be documented, negotiable flexibility. “Reasonable” needs to be documented as to how you arrived at that salary. It needs to take into consideration the skill and expertise you use to benefit the business, the number of hours you commit to it, what you would have to pay someone else to do the same job you are doing, the overall gross revenue of the entity as well as the net income, and other factors that may apply to your unique situation.
Whatever amount you determine, that reasonable salary needs to be paid, and it is subject to the appropriate payroll taxes. From that salary, you have the necessary income to make contributions to a 401(k) plan, solo or otherwise, or a Roth or traditional IRA. In fact, the only reason I can think of for one not to take a reasonable salary from their Sub-S entity is if the company does not have any money to pay anybody.