IRS guidelines on taking a salary for a S Corporation
Avoid possible penalties for not taking a salary as an S Corporation, by following IRS guidelines.
Many small business owners choose the S Corporation tax classification to enjoy the advantages that it provides. S Corporations have many benefits: pass-through taxation, shareholder liability limited to the amount of the initial investment, a simple and straightforward cash method of accounting, just to name a few.
If you are a corporate officer of an S Corporation, you are a shareholder and an employee at the same time. Both income and losses pass through to its shareholders’ personal tax returns to avoid double taxation on corporate income. Also, the business profits are not subject to Social Security (6.2%), Medicare (1.45%), or Unemployment taxes (~6% for 2020 applied to the first $7,000 paid as wages).
S Corporation corporate officers and directors decide on reasonable compensation for the employees (taxed at 15.3%), and how much of the profit to pay out as distributions (tax-free). You can see that S Corporations have a strong incentive to minimize their wages and maximize their distribution to avoid employment taxes. Shareholders, who do not perform any services or perform minor services for the S Corporation, can receive a low compensation or do not receive it at all. But when it comes to more than minor services, there are no specific IRS guidelines.
In efforts to protect employment tax revenue, the IRS and courts have been increasing their scrutiny of the payments to ensure that the characterization conforms to reality. If an S corporation owner avoids paying payroll taxes, the IRS will make the owner pay payroll tax penalties and negligence penalties. In this case the distribution would be treated as wages, which are subject to employment taxes.
When the IRS and S Corporation disagree on what compensation is reasonable, the parties enter the Tax Court. To understand if the compensation is reasonable, the Tax Court applies many tests based on different factors: employees’ training and experience, duties and responsibilities, time and effort devoted to the business, comparable business pay for similar services, and so forth. In the case of an IRS audit or dispute, S Corporation owners should be ready to justify the rationale behind their employees’ compensation. Need some help? Alron Payroll Inc. can help you determine reasonable compensation.
by Maria Climan – Content Creator at Half Full Marketing
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