‘S Wonderful, ‘S Marvelous, ‘S Unreasonable

By: Donna Ray Berkelhammer. This was posted Monday, April 7th, 2014

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One of the reasons to choose an S-Corp instead of an LLC is tax savings.  An S-corp does not pay any taxes at the corporate level, but instead all income is passed through to the shareholders, who are responsible for a number of taxes on both salary and dividends (return on investment).

The IRS and Department of Labor are cooperating to investigate companies that misclassify employees as independent contractors to try to avoid paying taxes.  The heightened scrutiny on payroll withholdings could make S-Corporations more likely to be audited.

Stack of Money

(Photo credit: 401(K) 2013)

With the S-Corp structure, the owners can take a “reasonable” salary (which is subject to both income tax, and, generally speaking, withholdings for social security, Medicare, and unemployment taxes). After the reasonable salary is paid, the owners can distribute the remainder of the profits, which are subject only to income tax.  These distributions are not treated as self-employment income, which is a tax advantage over LLCs, partnerships and sole proprietorships.

Determining what is a reasonable salary is tricky. Paying no salary compensation will trigger an audit, but so will paying too little salary compensation.  The IRS could recharacterize the resulting distributions as wages, and attach penalties for not withholding and paying proper payroll taxes.

Some shareholders decide not treat themselves as employees, but hire themselves as independent contractors to save on the payroll taxes. This can trigger an audit, and significant penalties for misclassification of workers.

As a general rule, zero salary is unreasonable as is a salary below the minimum wage.

The IRS will consider the following factors to determine whether a salary is reasonable (or too low):

  1. Employee qualifications;
  2. The nature, extent, and scope of the employee’s work;
  3. The size and complexity of the business;
  4. Prevailing general economic conditions;
  5. The employee’s compensation as a percentage of gross and net income;
  6. The employee-shareholder’s compensation compared with distributions to shareholders;
  7. The employee-shareholder’s compensation compared with that to non-shareholder employees or paid in prior years;
  8. Prevailing rates of compensation for comparable positions in comparable concerns; and
  9. Comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

If you have questions about the ratio of salary to distributions for your S-Corp, contact a business attorney.


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