One tax advantage of setting up your company as an S-Corporation is that the income is taxed on a “pass-through basis” to the shareholders and this pass-through income is not subject to self-employment tax. Since an S-corporation’s income which is taxed at the shareholder level is not subject to self-employment tax, the shareholders instead pay both the employer and employee share of payroll taxes on their salaries through the company’s payroll system.
When a business is set up as an S-corporation, shareholders assume they can pay themselves however and whenever they want to. In lieu of a salary, many shareholders compensate themselves through distributions or loan repayments, thus avoiding payroll taxes on these payments. The Internal Revenue Service (“IRS”) regulations and several court decisions have established that S-corporations need to pay a “reasonable” salary to shareholders who are officers of the corporation and who perform services for that corporation.
The obvious question that arises is what constitutes a reasonable salary for a shareholder. The IRS determines reasonable compensation on a case by case basis based upon several factors. These IRS factors include the training and experience of the shareholder, the shareholder’s duties and responsibilities within the business, time and effort devoted to the business and what comparable businesses pay for similar services. If a shareholder of an S-corporation does not take a reasonable salary, the tax courts have been known to reclassify distributions and loan payments as salary thereby subjecting the shareholder and their corporation to additional payroll taxes along with interest and penalties.
If you are considering setting up an S-corporation or are currently a shareholder of an S-corporation, please contact our office to further discuss this concept of “reasonable” compensation for shareholders.