The attraction of electing S corporation status is well known among business owners. However, there is a potential problem you might encounter if your business is organized as an S corp. IRS auditors are paying very close attention to the salary that S corp owners pay, or do not pay themselves.
S corporation income, losses, deductions and credits “pass through” the business to the owners to be reported on their individual tax returns. While distributions from the corporation are not subject to FICA withholding, the S corp owner is required to withhold FICA taxes—which amounts to 5.65% of the first $110,100 in salary earned through December 31, 2012. On January 1, 2013, FICA withholding reverts to 7.65% for the first $110,100 in salary earned. The employer portion remains at 7.65%.
The problem, as the IRS sees it, is that some S corporation owners may be tempted to give themselves artificially low salaries for the services they perform. Therefore, they reduce the amount owed in Social Security and Medicare payroll taxes. Then, they often take distributions to make up for the shortfall.
The following information was taken directly from the IRS website:
The Internal Revenue Service wants tax professionals and small-business owners to understand the law regarding corporate officers who perform services. By law, officers of corporations are employees for employment tax purposes, and their compensation is wages. The IRS has identified that some S corporations, in an effort to avoid employment taxes, are improperly treating payments for services to officers as “corporate distributions” rather than salaries. This attempt to characterize officers as non-employees does not work.
The Internal Revenue Code establishes that a corporate officer is an employee of the corporation for federal employment tax purposes. Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who does not perform any services or performs only minor services, and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.
To avoid a problem with the IRS, be sure to draw pay that the agency would consider a reasonable salary. Pay yourself what you would normally pay someone from the outside to perform the same job. You can check with a national association in your industry to determine what types of salaries are paid to executives.
For more information regarding this topic or any other tax-related issue, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.
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