Since an S-Corporation is not taxed at the entity level but rather each owner is taxed at the individual income tax rate on his or her respective ownership percentage of the business income, typically, the shareholder-employee wants to minimize compensation in favor of distribution to reduce payroll taxes. However, the IRS recognizes these incentives and establishes that the shareholder-employee cannot avoid the imposition of payroll taxes by forgoing “reasonable” compensation.
The IRS will monitor the distributions made to S-Corp owners to see if it is deficient and audit businesses which appear to pay unreasonable salaries, thoroughly examining the business’ gross receipts, claimed deductions, and services provided by each employee. If the compensation is not “reasonable” in such a way that unfairly reduces the business’ tax payments, the IRS has the ability to reclassify income as it sees fit. If income is reclassified, back taxes will be assessed, deductions will be disallowed, and interest and penalties will be owed.
To avoid an audit and reclassification, a business should set the salaries of its shareholder-employees with the consideration of the following factors:
- Nature of the S-Corporation’s business.
- Shareholder-employee qualifications, training and experience, duties and responsibilities, and time and effort devoted to business.
- Prevailing market salary figures for the same or a comparable position.
- Compensation as a percentage of corporate sales or profits.
- Compensation compared to that of non-shareholder employees or amounts paid in prior years.
- Compensation compared with distributions.
Please note that even if the business is losing money, some minimum amount of wages should be paid. A business may be able to avoid or set very low wages during its start up stage but cannot overcome the presumption that a person will eventually stop working for free or very low wages.
If you have any questions regarding reasonable compensation or setting up your S Corporation, please do not hesitate to contact us.