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Be Prepared for IRS Scrutiny of S Corporation Shareholder-Employee Salaries

April 24, 2014

S corporations’ unique tax treatment theoretically gives these entities the opportunity to save money by keeping salaries for shareholder-employees low and making profit distributions.

With S corporations — popular for their combination of limited liability and flow-through taxation — a shareholder’s proportionate share of company income isn’t subject to self-employment tax (Social Security and Medicare). This is a significant advantage over other flow-through entities, where all income that flows through to active owners for income tax purposes generally is subject to self-employment tax.

S corporations’ unique tax treatment theoretically gives these entities the opportunity to save money by keeping salaries for shareholder-employees low and making profit distributions. The potential savings might be even greater now that the Affordable Care Act’s (ACA’s) additional 0.9% Medicare tax on wages in excess of $200,000 ($250,000 for joint filers) has gone into effect. (S corporation distributions paid to active shareholders generally won’t be subject to the ACA’s 3.8% net investment income tax.)

But there’s a caveat: If the IRS finds that shareholder-employee salaries are “unreasonably” low, it can reclassify distributions and loans to shareholders as salary, imposing back employment taxes, interest and penalties.

What’s a “reasonable” salary? There’s no bright line definition or safe harbor amount; it all depends on the particular facts and circumstances. S corporations can increase the likelihood that salaries will be deemed reasonable by ensuring that they’re comparable to those for employees in similar roles at similar size businesses in their industry and geographic region.

Salaries should also take into account the shareholder-employee’s background, experience level, specific responsibilities, hours worked, professional reputation, and customer relationships. Salary surveys are one way to provide evidence of reasonableness. In addition, if an S corporation’s income is derived more directly from the shareholder-employees’ personal services than from the services of nonowner employees or from capital and equipment, then more of the shareholder-employee compensation should be classified as salary vs. profit distributions (i.e., profits are generated primarily by the services of the shareholder).

Setting shareholder-employee salaries requires a careful balance — salaries should be set high enough that they’ll pass muster with the IRS, but not so unnecessarily high that more employment tax is paid than is required. If you’d like help finding the right balance, please contact us.

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