In a recent blog post, we discussed some tax considerations when incorporating a business. Once a business reaches profitability, an owner or shareholder of an S corporation can take distributions of company profits, which do not require withholdings or payroll taxes.
But this comes with the caveat that an owner or shareholder must receive adequate compensation over distributions. This means it is often necessary to set a reasonable salary and go on payroll rather than only take large distributions of company profits. If the Internal Revenue Service questions the reasonableness of compensation, it may be necessary to mount an unreasonable compensation defense.
How does the IRS decide what is a reasonable salary?
Several years ago, the IRS audited law offices that had been incorporated as Sub S corporations. It found many violations. In one example, an attorney received a salary of $30,000, but his distributions in the same year neared $400,000. After the IRS reclassified some of the distributions as wages, the corporation owed additional payroll taxes, interest and penalties.
This mismatch is rather clear and it is unlikely that even a newly licensed attorney would take a position that paid $30,000 per year. This is actually the first test – what would an individual in the field generally expect to earn?
However, only working a few hours each week for the corporation might justify such a scenario. A semi-retired partner who only spent 10 hours a week in the office may take a smaller salary, but larger distributions.
The number of employees in relation to owners and shareholders may also enter into the analysis. If a company had one owner and a part-time bookkeeper, most of the compensation paid to the owner should likely be classified wages rather than distributions in order to be reasonable.
This area of the law is quite complex and there is no firm rule on what is reasonable. When the IRS questions a distribution, an experienced tax attorney can help build a defense.
Source: FOX Business, "Reasonable Compensation and Your S Corporation," Bonnie Lee, August 11, 2014.