Many small business owners operate as a solely owned S corporation. Distributions from S corporations occur in one of two ways: first, the S corporation pays the owner/employee a salary for his or her service; second, the owner/shareholder of an S corporation receives a distribution as a shareholder of the corporation from the income generated by the S corporation.
Why does this matter you ask? Simply put, taxes. While both forms of compensation are reportable as taxable income by the owner on his/her individual income tax, a salary received from an S corporation is subject to payroll taxes (social security and Medicare) while distributions from an S corporation are not.
This drastic difference in taxes led many S corporation owners to forego receiving any salary in an attempt to avoid these payroll taxes and instead only receive distributions. However, the IRS recognized this attempt to avoid payroll taxes and stepped up its enforcement on this issue by auditing thousands of S corporations that paid their owners little or no salary.
If the IRS concludes that an S corporation owner attempted to evade payroll taxes by disguising salary as corporate distributions, it can recharacterize the distributions as salary and require the payment of payroll taxes that should have been paid as well as assess additional penalties.
The rule of thumb is that an S corporation owner who provides substantial services should be treated as an employee (employee/shareholder) and compensated accordingly. However, when an IRS challenges the salary paid to an S Corporation owner, the following factors are considered by Courts when determining if a reasonable salary was paid:
- Nature of the S Corporation’s Business: Is the company a professional services corporation/one where profits are generated primarily through the personal efforts of the employees OR does the company generate profits more by the capital and assets of the corporation i.e. accounting and real estate activities vs. manufacturing.
- Employee Experience, Duties, Responsibilities, and Time Spent: A highly trained, experienced employee/shareholder who is charged with the time-intensive responsibilities of handling the corporation’s should be paid a salary proportional to these factors.
- How Much are Non-shareholder Employees Paid and What was Received Previously?: If an employee/shareholder has more experience, expertise or responsibilities than the highest paid non-shareholder/employee, then the employee/shareholder’s wages should be based off of this other salary at the bare minimum. Additionally, if the corporation has enjoyed rising revenues but the employee/shareholder’s salary has not also risen, then the IRS may allege that the compensation is unreasonably low.
- Industry Salary Range: Is the salary commensurate with salary norms for the local industry?
- Profitability of Corporation: Is the company more profitable than its local peers, if so, the salary paid to its employee/shareholder should reflect this fact unless extenuating circumstances exist i.e. employee/shareholder’s reduced role or the corporation’s need to retain capital for expansion.
- Compensation vs. Distribution: What is the ratio between the salary and distribution received by the employee/shareholder? The IRS has generally sought to recharacterize compensation to ensure that an employee/shareholder’s salary exceeded the Social Security wage base for a given year. Therefore, as long as that threshold is met, distributions significantly larger than a salary are generally permissible.
Ultimately, all S corporation owners who provide his/her services to the corporation need to be paid a reasonable salary. Exactly what the IRS will consider a reasonable salary dependes on the unique set of circumstances for each given situation. However, making sure that at least some salary (even if it is on the low-end of the scale) is paid to an employee/shareholder will avoid falling into the trap of the old saying “Pigs get fed and hogs get slaughtered.” Contact our office to discuss what sort of salary you should consider to ensure that the IRS does not argue that you are being too hoggish.