Qualifying as an S Corporation has significant advantages for shareholders. One of the biggest is avoiding double taxation on corporate income. These corporations pass all income, losses, deductions, and credits to their shareholders for federal tax purposes.

The one tax that S Corporations must pay is the payroll tax. Wages paid to any shareholder-employee must meet all federal employment tax requirements.

At the same time, any profit distributions to shareholders aren't subject to payroll taxes. The result is a tempting loophole: Classifying income as distributions to avoid payroll taxes.

The IRS has responded by increasing audits of S corporations. The agency has also attempted to limit this misclassification by requiring reasonable compensation of employees.

What is Reasonable Compensation?

The IRS classifies shareholders who provide more than minor services as employees, and these individuals should receive wages. Any wages that a company pays are subject to payroll and other employment-related taxes.

Courts have repeatedly found that S corporations cannot evade this requirement by classifying income as distributions. Corporations also cannot avoid employment taxes by claiming a sum is either a loan or a loan repayment.

To that end, S Corporations are required to pay appropriate and reasonable salaries to employee-shareholders. This can also include medical insurance.

The IRS will consider multiple factors when determining if a shareholder is an employee and if they are receiving reasonable compensation. These can include:

• What comparable businesses pay for similar services
• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• Compensation agreements
• The use of a formula to determine compensation

In other words, the IRS will look at the circumstances and how they compare to others in similar positions to determine if a shareholder-employee is earning reasonable compensation.

One other thing to note: The IRS has the authority to reclassify any distribution or other payment made to an employee-shareholder as wages. In some cases, this reclassification will require that an S Corporation pay employment taxes. The organization may also be required to pay penalties and interest.

If you have questions about how to structure S Corporations and potential tax liability, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.