For years the S-Corporation has been an extremely popular entity selection for small and mid-sized business owners. But recently (the past 5 years or so), the IRS has paid closer attention to S-Corporations and the reasonableness of an active shareholder’s compensation. One of the advantages of having an S-Corporation is that the entity itself does not pay any federal income taxes. The tax liability is shifted to the shareholders at the individual level. It is not uncommon to find active shareholders paying themselves next to nothing to reduce the amount of payroll taxes they would be required to pay on their salaries. Taking compensation from profits instead of a salary helped shareholders ‘get around’ payroll taxes.
While most business owners love this practice, the IRS continues to overturn a high percentage of these cases causing the business owners to reclassify the distributions as compensation subject to payroll taxes.
Things to consider; the IRS looks at several factors when evaluating active shareholders compensation:
- What is the nature of the S-Corporation’s business?
- What are the active shareholder’s qualifications, responsibilities, time and effort devoted to the business?
- How does the shareholder’s compensation compare to non-shareholder employees compensation?
- What do comparable businesses pay for similar services?
- What is compensation as a percentage of corporate sales and profits?
- How does compensation compare to distributions taken?
If you are an S-Corporation and are active in the business, Keystone recommends you consider all of these factors. Have a conversation with your tax advisor to determine what results you may have if the IRS were to audit you.