Beware of the IRS Reclassifying Your S Corporation Distributions as Wages

If you run your business as an S corporation, you’re probably both a shareholder and an employee. Therefore, the company should pay you a salary for the work you do for the business, which is subject to payroll taxes as well as income tax withholding.

By distributing profits in the form of dividends rather than salary, an S corporation and its owners avoid payroll taxes on these amounts. Because of the increasing taxable Social Security wage base and additional Medicare tax on wages in excess of $200,000 ($250,000 for joint filers and $125,000 for married filing separately), the potential tax savings from classifying payments as dividends rather than salary may be even greater than before.

IRS audit risk

But paying little or no salary is risky. The IRS targets S corporations with owners’ salaries that it considers unreasonably low and will assess unpaid payroll taxes, penalties and interest. This can become very costly.

To avoid such an onerous result, S corporations should establish and document reasonable salaries for each position using compensation surveys, comparable industry studies, company financial data and other evidence. The reasons for compensation amounts should be recorded in your corporate minutes. Our Boca Raton tax planning services can help in the review of the minutes before being finalized.

Is your salary reasonable?

While, there are no specific guidelines for reasonable compensation in the tax code or regulations, various courts, have ruled on this issue. Their decisions have been based on the facts and circumstances of each case. Factors considered in determining reasonable compensation include:

• Training and experience
• Educational Background
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-owner employees
• Timing and manner of paying bonuses to key people

Determine the best mix

Do you have questions about S Corporation compensation? We can assist you in determining the appropriate mix of salary and dividends that can keep your tax liability as low as possible while standing up to IRS audit. Call us today for professional tax planning services in Boca Raton and elsewhere in South Florida.