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Attention S Corp. Owners: BE REASONABLE

Small business owners like the S corporation business structure for several reasons, two of which are tax related. For federal income-tax purposes, an S corporation’s profits “pass through” and are taxed to individual shareholders. C corporation profits, on the other hand, are taxed twice — once at the corporate level and again at the share­holder level when paid out as dividends.

The other potential tax benefit involves federal employment taxes. S corporation owners/employees can — and often do — keep employment taxes down by paying themselves low salaries. But they make up for that by compensating themselves with payments that are not subject to employment taxes (e.g., cash distributions). That’s not always a good strategy. The IRS is on the lookout for owners who report low or no wages on their tax returns.

The U.S. Tax Court recently ruled in favor of the IRS in a case that pitted the agency against the sole owner of a real estate firm. The owner was in charge of every aspect of the business and often worked 12-hour days without taking any time off in between. The trouble is, the owner didn’t report any wages on his tax return.

After studying the facts and circumstances of the case, the Tax Court arrived at what it deemed to be a reasonable hourly rate ($40) and ruled that the business should have paid the owner wages of $83,200 for the year. As a result, the owner owed significant employment taxes and penalties.

The moral of the story is that if you perform services for your company and you don’t take a reasonable salary, the IRS may be able to reclassify dividends, distributions, or loans you’ve received as salary — and you could end up owing employment taxes and penalties as a result. That doesn’t mean there aren’t opportunities for tax savings. You can avoid paying unnecessary employment taxes by paying yourself a reasonable salary.

Original content provided by: Client Line Newsletter