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S Corporation shareholders enjoy limited personal liability and a beneficial pass-through structure; income and losses pass through the corporation and to the owner’s personal tax returns. With this tax structure, shareholder distributions from an S corporation aren’t treated as self-employment income, hereby avoiding the high self-employment tax rate on their share of the income. This allows for savings on payroll taxes since such taxes are not paid on shareholder distributions. However, an S corporation shareholder performing more than minor services for the corporation is considered an employee for tax purposes, as well as a shareholder, and needs to be paid as such. The IRS is paying close attention to S corporations, and when shareholders aren’t paid a reasonable salary it’s a major red flag and the likelihood of an audit goes up drastically.

To prevent S corporations and their shareholders from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS requires that S corporation shareholders who provide services receive reasonable compensation. To determine a reasonable shareholder salary, consider how you would find a reasonable salary amount for any new employee. The IRS guidelines suggest that you look at the following factors to determine what is a “reasonable” salary for your corporate officers:

-Training and experience

-Duties and responsibilities

-Time and commitment to the business

-Payments to non-shareholder employees

-Distribution history

-Timing and manner of paying bonuses to key people

-What comparable businesses pay for similar services

Your ability to substantiate the salaries you are paying shareholders will help keep you on the right side of the IRS when it comes time for them to review your company’s tax returns. If the IRS concludes that an S corporation shareholder has attempted to evade paying payroll taxes by disguising employee salary as corporate distributions, it can re-characterize the distributions as salary and require payment of employment taxes and penalties. These penalties can include payroll tax penalties of up to 100% plus negligence penalties.

S corporation shareholders should consider the following:

Salaries vs. Distributions: Owners of S corporations should receive paychecks with payroll tax withholdings, but also have the option of taking additional money beyond your salary in the form of a distribution. Since the IRS does not confirm a percentage threshold for salary compensation, discuss a reasonable figure with your CPA.

Choose a Reasonable Salary: The IRS is cracking down on S corporations that misclassify payments to shareholder-employees as distributions. Unfortunately, there is no way to guarantee the salaries you set will square with what the IRS thinks is reasonable. But if you do your homework and show that you have made a good faith effort to pay reasonable salaries, the IRS is more likely to defer to your judgment.

Watch Out For Fringe Benefits: Normally, the cost of health insurance premiums for employees is a deductible expense for a business. However, there is a special exception for S corporations, which are not allowed the deduction for health insurance paid for shareholder-employees who own more than 2% of the company. The S corporation must include those payments with its shareholder-employee wages when it issues annual W-2s. By reporting these payments as wages, S corporations are still able to use them as a deduction.

Restrict Stock Ownership: C corporations have virtually no restrictions on who can own stock, but S corporations have quite a few. You can only have a maximum of 100 shareholders and only one class of stock (although you can issue stock that doesn’t have voting rights). Also, you cannot allow a partnership, corporation, or foreign person to be a shareholder. Violating any of these guidelines could cause the IRS to terminate your S corporation status.

Since a reasonable salary is a subjective number, you should have some justification for the salary you choose, and should consult with your trusted CPA to set an appropriate figure. Counsel can advise you on establishing reasonable compensation for your officers and can help implement the right tax plan to maximize the growth of your business.

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