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As a former transactional/commercial litigation attorney I too would see this issue regularly. One interesting "hack" I would see clients do regularly as owner

As a former transactional/commercial litigation attorney I too would see this issue regularly. One interesting "hack" I would see clients do regularly as owner/employees, they would minimize their own salary to avoid payroll taxes, maximizing their distributions (distributions are not subject to payroll taxes). Unfortunately for them the IRS accounts for this hack, and if an IRS audit finds the salary isn't reasonable then those amounts will be subject to payroll, social security, medicare, potentially higher income tax, and moving forward affordable care act taxes plus penalties and interest. I personally hate this because there is no bright line rule as to what a reasonable salary is subjecting all business owners to the mercy of the IRS. I am surprised this would happen to a YC company, not that YC is in anyway responsible, but I figured YC would be in a position to offer various business services (payroll, legal, tax, insurance, ect...) at extremely low cost. For example, I personally solicited YC and offered to provide Delaware incorporation/registered agent/annual compliance services to any YC companies at a discount which without the discount is already cheaper than legalzoom.

tptacek 12y ago
It's a hack, and it's also unfair. S-corp company owners get to inhabit a very small part of the economy that, due to a loophole, gets a dial that turns some of their liquid compensation from "salary" to "investment income". That's baloney. I'm glad it's an audit flag.
- swombat 12y ago
  It's not much of a problem in the UK. A great many of our clients (and ourselves) use the standard dividends + minimum wage method of paying themselves - that is, the ones who own their businesses, i.e. have not taken funding. HMRC accepts this method as a way for business owners to minimise their taxes. As I recall, the argument is something along the lines of "I am paying myself a salary for the basic director duties but effectively working for free on the company day to day, and collecting parts of the earnings as an owner." It works fine and is very common for small businesses in the UK. I guess this goes to show how contextual accounting advice can be. On that note, I'll add that I'm ever so glad that in all my interactions with them HMRC have been polite, friendly, supportive, helpful and nothing like the abusive business murderers that the IRS appear to aim to be - even when I fucked something up that was obviously my fault. I don't understand why the IRS feels that they need to be such assholes about everything. They should see their job as what it is: an essential part of the infrastructure that supports the economy and, indirectly, supports businesses. Their role should be to make business easier, not harder.
  - tptacek 12y ago
    I've never had an unpleasant interaction with the IRS. Unlike virtually any other creditor I've ever dealt with, the people I've talked to who actually work for the IRS have been courteous and helpful. I'm not the only person who's said this. The IRS has acquired a personalized reputation for being jerks, not unlike that of Customs, but which totally doesn't square with how the agency actually acts. I say this as someone who once had a pretty decent unexpected 5-figure liability that I had to work out with them. I also don't feel like zealous enforcement of unremitted payroll tax is particularly abusive, since that's essentially describing companies stealing from their employees.
    - swombat 12y ago
      Well, that's good to hear! This reputation the IRS has makes me worried about the idea of some day operating in the US. It's good to know that they actually employ human beings rather than attack dogs. From what you describe, they sound much like HMRC. And yes, withholding payroll tax (or VAT) and not passing it on to the government is pretty crappy. HMRC is typically understanding if this is a few months or even a year down the line and they think the business will be able to pay up - they frequently agree payment plans for such things - but three years without noticing kinda takes the piss.
      - mikeash 12y ago
        I get the impression (and I could be woefully wrong) that the IRS, kind of like the USPS, has an awful reputation that was justified some decades ago, has turned it around because of that awful reputation, but inertia means the reputation persists long after the underlying reasons have been remedied.
    - larrys 12y ago
      I think I'm a bit older than you. They were "jerks" back when I started in business. But things have changed as you've pointed out. I had a run in with the labor department at my first company. I wouldn't exactly call them jerks (or nice) but I was able to get them to cut in half a 5 figure amount they assessed me (a lawsuit was filed) by having a personal meeting with the local office head. Without an attorney. After I cut the deal I then said "oh one more thing can I have 5 years to pay this back?". And he agreed (I didn't need the 5 years, it wasn't a large amount, but I thought why not?)
- bravo22 12y ago
  Actually as an S-Corp owner all the corporate income is taxed as REGULAR INCOME. It doesn't become a capital gains tax -- which is what I assume you mean by investment income. However the US government wants you to also pay Social Security and Medicare tax, which you only pay on employment income. Therefore they force you to take a "reasonable"[1] salary from the company. Everything else left in the company's account at the end of the year is your non-employment income. It avoids double taxation. It doesn't put you in a lower tax bracket. 1. Reasonable is determined by them.
  - tptacek 12y ago
    It's taxed as regular income, but the premise under which it's exempt from the payroll taxes every other worker has to pay is that it's not normal income, but rather the return from an investment in the company. For people in our industry, it's hard to see a definition of "reasonable" that would be financially beneficial. You start a tech company. You pull $100k out every year, putting you right smack in the middle of the income distribution for experienced tech people. But because of a loophole, you get to reclassify $50k of that $100k as a distribution, and not pay FICA on it. To support that (sorry) scam, you claim $50k is your "reasonable" salary --- putting you way on the low side of the industry. How convenient. People obviously do it and get away with it. I'm glad it's an audit flag.
    - moggflunkies 12y ago
      lol @ you forgetting that other businesses exist that operate in the margins of this kind of expense. That sorry scam may be the difference between a local hardware store, mechanic, coffee shop staying open and closing. Even owner/operators don't want to work for reduced wages. It's even more sorry to sit around on HN and forget that there are many more businesses that are as important or more important than a mobile app service for checking on and generating QR codes for sales at local restaurants. The IRS gets theirs, don't worry about that. It's just too bad that the spending side of the function is broke, not the revenue.
    - cullenking 12y ago
      Sure, but you just mentioned an unreasonable salary. If the median is $100k, then that's reasonable, and the person only gets to avoid SS and medicare on any additional profit. I operate as an s-corp and pay myself a reasonable salary, matching that of the salary I could get in the current job market in the area I live in. Anything I clear above this is only taxed with my regular taxes. If I was running a C-Corp instead of an S-Corp, I'd get my $100k salary, and any extra would have been taxed at the 30% corporate rate when it was taken in, then the 20% capital gains when it's distributed to me as profit.
mynewwork 12y ago
There are multiple very large public companies in the US which boast that their CEO earns a salary of only $1. See: http://en.wikipedia.org/wiki/One-dollar_salary http://en.wikipedia.org/wiki/One-dollar_salary Is there some difference between the type of corporation which makes it acceptable, or could the IRS potentially go after all of those individuals?
- snowwrestler 12y ago
  The companies probably pay payroll taxes for these individuals on a higher "salary" number that is reasonable for their position.
extesy 12y ago
How is $1 salary justified to IRS? There are a bunch of executives who have $1 salary [0], including Mark Zuckerberg. I really doubt it's considered reasonable. [0] http://en.wikipedia.org/wiki/One-dollar_salary http://en.wikipedia.org/wiki/One-dollar_salary
- larrys 12y ago
  "How is $1 salary justified to IRS? " What they report to the IRS and what they show on financials could be 2 totally different things. Entirely possible that they are paying taxes on a higher salary.
  - zohaibr 12y ago
    Base Salary is just a tiny component of an executive's salary. It is a PR move. Executive salary is made up of Cash component (which includes Base Salary & Bonuses), & Equity. Equity constitutes towards almost 99 percent of an exec's salary. There are short term equity plans and long term equity plans. The equity payouts are generally in millions. Companies have to release a DEF14A (30-40 pages) each year to show Shareholder's how much the Top5 Execs were paid each year.
- snowwrestler 12y ago
  You don't have to justify low salaries to the IRS conceptually, you just can't use them to avoid paying payroll taxes. I would assume that companies like Apple and Facebook have competent tax teams that make sure their obligations are fulfilled, even if that means paying payroll taxes on a portion of the stock-based compensation to their executives.
larrys 12y ago
"Unfortunately for them the IRS accounts for this hack, and if an IRS audit finds the salary isn't reasonable then those amounts will be subject to payroll, social security, medicare, potentially higher income tax, and moving forward affordable care act taxes plus penalties and interest. " My experience over time with many business people has shown that since we are not talking about a criminal action but an action that will result in only penalties, interest etc. it is probably a chance worth taking. This is a frequent occurrence in business in other areas. You have to take your chances and you determine the chances that you take by looking at your comfort level (which is different for everyone) with the potential downside and probability of that downside happening.
jacquesm 12y ago
In NL we actually do have such a 'bright line', a very reasonable amount that anybody in the hot seat is required to pay out of their business on an annual basis as a salary. If the business is not doing well you can negotiate that down to ridiculously low levels provided you do not borrow from the company at the same time. That last bit is the bit that bites, many business owners already have a line of credit with their company from the founding days and they'd have to pay that back before they can reduce their salary. On the whole that arrangement works well though, and the one time that I needed it I found that the tax people were very much understanding of the situation and offered a few suggestions that helped making things easier. If all government institutions were as reasonable as the tax office in my dealings with them this would be a much better country.
- maxerickson 12y ago
  In the U.S., if you pay yourself the wage base limit, then you at least won't be delinquent for any social security taxes: http://www.irs.gov/taxtopics/tc751.html http://www.irs.gov/taxtopics/tc751.html So people doing high value software type consulting are probably playing games if they take that much compensation but oops on fully paying those particular taxes.
- roel_v 12y ago
  "In NL we actually do have such a 'bright line', a very reasonable amount that anybody in the hot seat is required to pay out of their business on an annual basis as a salary." That is the floor, it's not a 'bright line'. If the field of that particular business the 'usual salary' is higher, you have to pay yourself that, and you're at the mercy of the tax office in the same way, because they decide what is the 'usual salary'. Also, a director is not allowed to pay themselves less than their employees, for example. That said, it is true that it is fairly easy to get into contact with an inspector and get advice on how to proceed.
walshemj 12y ago
So how do the 1$ salary CEO's get away with this its an obvious tax avoidance scheme that I would have thought the IRS would be all over it.

tptacek 12y ago

It's a hack, and it's also unfair. S-corp company owners get to inhabit a very small part of the economy that, due to a loophole, gets a dial that turns some of their liquid compensation from "salary" to "investment income". That's baloney. I'm glad it's an audit flag.

swombat 12y ago
It's not much of a problem in the UK. A great many of our clients (and ourselves) use the standard dividends + minimum wage method of paying themselves - that is, the ones who own their businesses, i.e. have not taken funding. HMRC accepts this method as a way for business owners to minimise their taxes. As I recall, the argument is something along the lines of "I am paying myself a salary for the basic director duties but effectively working for free on the company day to day, and collecting parts of the earnings as an owner." It works fine and is very common for small businesses in the UK. I guess this goes to show how contextual accounting advice can be. On that note, I'll add that I'm ever so glad that in all my interactions with them HMRC have been polite, friendly, supportive, helpful and nothing like the abusive business murderers that the IRS appear to aim to be - even when I fucked something up that was obviously my fault. I don't understand why the IRS feels that they need to be such assholes about everything. They should see their job as what it is: an essential part of the infrastructure that supports the economy and, indirectly, supports businesses. Their role should be to make business easier, not harder.
- tptacek 12y ago
  I've never had an unpleasant interaction with the IRS. Unlike virtually any other creditor I've ever dealt with, the people I've talked to who actually work for the IRS have been courteous and helpful. I'm not the only person who's said this. The IRS has acquired a personalized reputation for being jerks, not unlike that of Customs, but which totally doesn't square with how the agency actually acts. I say this as someone who once had a pretty decent unexpected 5-figure liability that I had to work out with them. I also don't feel like zealous enforcement of unremitted payroll tax is particularly abusive, since that's essentially describing companies stealing from their employees.
  - swombat 12y ago
    Well, that's good to hear! This reputation the IRS has makes me worried about the idea of some day operating in the US. It's good to know that they actually employ human beings rather than attack dogs. From what you describe, they sound much like HMRC. And yes, withholding payroll tax (or VAT) and not passing it on to the government is pretty crappy. HMRC is typically understanding if this is a few months or even a year down the line and they think the business will be able to pay up - they frequently agree payment plans for such things - but three years without noticing kinda takes the piss.
    - mikeash 12y ago
      I get the impression (and I could be woefully wrong) that the IRS, kind of like the USPS, has an awful reputation that was justified some decades ago, has turned it around because of that awful reputation, but inertia means the reputation persists long after the underlying reasons have been remedied.
  - larrys 12y ago
    I think I'm a bit older than you. They were "jerks" back when I started in business. But things have changed as you've pointed out. I had a run in with the labor department at my first company. I wouldn't exactly call them jerks (or nice) but I was able to get them to cut in half a 5 figure amount they assessed me (a lawsuit was filed) by having a personal meeting with the local office head. Without an attorney. After I cut the deal I then said "oh one more thing can I have 5 years to pay this back?". And he agreed (I didn't need the 5 years, it wasn't a large amount, but I thought why not?)
bravo22 12y ago
Actually as an S-Corp owner all the corporate income is taxed as REGULAR INCOME. It doesn't become a capital gains tax -- which is what I assume you mean by investment income. However the US government wants you to also pay Social Security and Medicare tax, which you only pay on employment income. Therefore they force you to take a "reasonable"[1] salary from the company. Everything else left in the company's account at the end of the year is your non-employment income. It avoids double taxation. It doesn't put you in a lower tax bracket. 1. Reasonable is determined by them.
- tptacek 12y ago
  It's taxed as regular income, but the premise under which it's exempt from the payroll taxes every other worker has to pay is that it's not normal income, but rather the return from an investment in the company. For people in our industry, it's hard to see a definition of "reasonable" that would be financially beneficial. You start a tech company. You pull $100k out every year, putting you right smack in the middle of the income distribution for experienced tech people. But because of a loophole, you get to reclassify $50k of that $100k as a distribution, and not pay FICA on it. To support that (sorry) scam, you claim $50k is your "reasonable" salary --- putting you way on the low side of the industry. How convenient. People obviously do it and get away with it. I'm glad it's an audit flag.
  - moggflunkies 12y ago
    lol @ you forgetting that other businesses exist that operate in the margins of this kind of expense. That sorry scam may be the difference between a local hardware store, mechanic, coffee shop staying open and closing. Even owner/operators don't want to work for reduced wages. It's even more sorry to sit around on HN and forget that there are many more businesses that are as important or more important than a mobile app service for checking on and generating QR codes for sales at local restaurants. The IRS gets theirs, don't worry about that. It's just too bad that the spending side of the function is broke, not the revenue.
  - cullenking 12y ago
    Sure, but you just mentioned an unreasonable salary. If the median is $100k, then that's reasonable, and the person only gets to avoid SS and medicare on any additional profit. I operate as an s-corp and pay myself a reasonable salary, matching that of the salary I could get in the current job market in the area I live in. Anything I clear above this is only taxed with my regular taxes. If I was running a C-Corp instead of an S-Corp, I'd get my $100k salary, and any extra would have been taxed at the 30% corporate rate when it was taken in, then the 20% capital gains when it's distributed to me as profit.

mynewwork 12y ago

There are multiple very large public companies in the US which boast that their CEO earns a salary of only $1. See: http://en.wikipedia.org/wiki/One-dollar_salary http://en.wikipedia.org/wiki/One-dollar_salary Is there some difference between the type of corporation which makes it acceptable, or could the IRS potentially go after all of those individuals?

snowwrestler 12y ago
The companies probably pay payroll taxes for these individuals on a higher "salary" number that is reasonable for their position.

extesy 12y ago

How is $1 salary justified to IRS? There are a bunch of executives who have $1 salary [0], including Mark Zuckerberg. I really doubt it's considered reasonable. [0] http://en.wikipedia.org/wiki/One-dollar_salary http://en.wikipedia.org/wiki/One-dollar_salary

larrys 12y ago
"How is $1 salary justified to IRS? " What they report to the IRS and what they show on financials could be 2 totally different things. Entirely possible that they are paying taxes on a higher salary.
- zohaibr 12y ago
  Base Salary is just a tiny component of an executive's salary. It is a PR move. Executive salary is made up of Cash component (which includes Base Salary & Bonuses), & Equity. Equity constitutes towards almost 99 percent of an exec's salary. There are short term equity plans and long term equity plans. The equity payouts are generally in millions. Companies have to release a DEF14A (30-40 pages) each year to show Shareholder's how much the Top5 Execs were paid each year.
snowwrestler 12y ago
You don't have to justify low salaries to the IRS conceptually, you just can't use them to avoid paying payroll taxes. I would assume that companies like Apple and Facebook have competent tax teams that make sure their obligations are fulfilled, even if that means paying payroll taxes on a portion of the stock-based compensation to their executives.

larrys 12y ago

"Unfortunately for them the IRS accounts for this hack, and if an IRS audit finds the salary isn't reasonable then those amounts will be subject to payroll, social security, medicare, potentially higher income tax, and moving forward affordable care act taxes plus penalties and interest. " My experience over time with many business people has shown that since we are not talking about a criminal action but an action that will result in only penalties, interest etc. it is probably a chance worth taking. This is a frequent occurrence in business in other areas. You have to take your chances and you determine the chances that you take by looking at your comfort level (which is different for everyone) with the potential downside and probability of that downside happening.

jacquesm 12y ago

In NL we actually do have such a 'bright line', a very reasonable amount that anybody in the hot seat is required to pay out of their business on an annual basis as a salary. If the business is not doing well you can negotiate that down to ridiculously low levels provided you do not borrow from the company at the same time. That last bit is the bit that bites, many business owners already have a line of credit with their company from the founding days and they'd have to pay that back before they can reduce their salary. On the whole that arrangement works well though, and the one time that I needed it I found that the tax people were very much understanding of the situation and offered a few suggestions that helped making things easier. If all government institutions were as reasonable as the tax office in my dealings with them this would be a much better country.

maxerickson 12y ago
In the U.S., if you pay yourself the wage base limit, then you at least won't be delinquent for any social security taxes: http://www.irs.gov/taxtopics/tc751.html http://www.irs.gov/taxtopics/tc751.html So people doing high value software type consulting are probably playing games if they take that much compensation but oops on fully paying those particular taxes.
roel_v 12y ago
"In NL we actually do have such a 'bright line', a very reasonable amount that anybody in the hot seat is required to pay out of their business on an annual basis as a salary." That is the floor, it's not a 'bright line'. If the field of that particular business the 'usual salary' is higher, you have to pay yourself that, and you're at the mercy of the tax office in the same way, because they decide what is the 'usual salary'. Also, a director is not allowed to pay themselves less than their employees, for example. That said, it is true that it is fairly easy to get into contact with an inspector and get advice on how to proceed.

walshemj 12y ago

So how do the 1$ salary CEO's get away with this its an obvious tax avoidance scheme that I would have thought the IRS would be all over it.