Shifting S income with salary adjustments.

Along with increasing the income tax rates on high income taxpayers, the Revenue Reconciliation Act of 1993 reduced the amount of compensation taken into account for qualified retirement plan purposes to $150,000 (adjusted for inflation), and repealed the Medicate wage base ceiling. In light of these changes, one may want to review reducing and owner-employee's salary from an S corporation.

Advantages of an owner-employee in an S corporation reducing his salary include:

* Reduction in payroll taxes. However, see Radtke, S.C., 895 F2d 1196 (7th Cir. 1990), in which the IRS was successful in recharacterizing distributions as salary when a shareholder in a closely held professional service corporation performed substantial services and received no pay. The Service assessed back payroll taxes, penalties and interest. In addition, President Clinton's health plan would require more-than-2% shareholders of professional or service organizations to pay social security taxes on their pro rata share of S income.

* Shifting of income to family members who also own stock in the S corporation and are in a lower income tax bracket.

* Avoiding a reduction in social security benefits for too much earned income if the owner-employees is under the age of 70.

* Payment of salary may cause the corporation to incur a loss for the year and make the accumulated adjustments account (AAA) negative. If the S corporation has accumulated earnings and profits and also has a negative AAA, future distributions may be taxed as dividends.

Other considerations in reviewing whether to reduce an owner-employee's salary are:

* Sec. 1366(e) authorizes the IRS to reallocate income among family members if the shareholder is paid too little for services rendered.

* The effect on any qualified or nonqualified deferred compensation plan benefits. (For example, plan benefits may be based on an average of compensation paid to the participant for the three years prior to retirement.)

* The effect on buy-sell formulas based on earnings.

Another way to reallocate S income is to hire a family member in a tax bracket lower than the shareholder's (e.g., a minor child). However, the salary paid to the family member must be reasonable in relation to the services rendered. Also, any wages would be subject to FICA tax, since the FICA exemption for children under the age of 18 does not apply to a child employed by a corporation owned by a parent.