USA Return of capital investment subject to 60/40 approach for S-Corp?

[Angie]

I know as a general rule of thumb S-Corporation officers want to have salaries and distributions in a 60/40 ratio, with the idea that they don't avoid payroll taxes by distributing funds and not taking an adequate salary.

I have clients who have had profits for a few years but always left the funds in the company (while taking a reasonable salary). They have recently begun taking funds out. Would these funds coming out be considered distributions (subject to the 60/40 rule of thumb) or just return of capital (with no ratio rule of thumb) until they remove their initial investment? The IRS states "A distribution generally qualifies as a return of capital if the corporation making the distribution doesn't have any accumulated or current year earnings and profits."

 

[Tyson]

The 60/40 thing is just a rule of thumb, as you said. It's not a rule or a law. If the shareholder-employees are being paid a reasonable/competitive salary, it does not matter how little or how much is distributed. You can just ignore that rule of thumb.

Also thinking of cash withdrawals as either distributions or return of capital will just confuse you. It's better to think of cash withdrawals as something more like withdrawing profits from an investment. The profits of the business are taxed on the individual-level at the end of every year. The profits that they did not withdraw during the year could be thought of as being withdrawn and then immediately reinvested back into the business. Think of the profits that are reinvested as becoming part of the shareholder-employee's portions of contributed capital.

Now when a cash withdrawal is made it is made against the balance of contributed capital that the shareholder-employee has accumulated/invested. Taxes are paid on the profits of the business irrespective of whether or not cash is withdrawn.

Does this make sense?
This article has a more thorough explanation than mine: http://www.thetaxadviser.com/issues/2014/jan/nitti-jan2014.html

 

[Angie]

Thanks for your response Tyson. I agree that the requirement of the reasonable salary is really the official rule the IRS is looking at here. I think focusing on that with my clients would really resolve any perceived issue.

As far as the reasonable salary goes, do you think that as a company earns more, that a reasonable salary should in theory increase? That's really how this issue came up; the company is performing better, so they are wanting to take more funds out now, but haven't increased their salaries. That being said, they haven't increased the salaries of any other employees either. I would argue their duties/hours haven't changed significantly.

 

[Tyson]

Look at how much people with similar jobs in similar size companies are being paid. Use that as a benchmark to determine what is reasonable. That's what the IRS would do.