One of the best perks of starting your own business is being able to determine your salary—unless, of course, you pay yourself the wrong amount and the IRS comes calling. Is there a wrong amount? Yes, there can be, and if you file taxes as an S Corp, the IRS will carefully scrutinize how you pay yourself and how you distribute dividends to shareholders. The key is understanding the flexibilities and restrictions of the S Corp.
What Is an S Corp?
S corporations aren’t really a legal business entity type, but instead a special election that either an LLC or C Corp makes with the IRS. Most entrepreneurs who choose S Corp status do so as a way to enjoy the same liability protection as LLCs and C Corps, while also avoiding the double taxation inherent in the C Corp.
S Corps elect to pass corporate income, losses, deductions and credits through to shareholders for federal tax purposes. Shareholders then report the flow-through income and losses on their personal tax returns and are assessed tax at their individual income tax rates.
Of course, there are restrictions on which corporations can function as an S Corp. The business must:
- Be a U.S. corporation
- Have shareholders who are U.S. citizens or permanent residents
- Have no more than 100 shareholders
- Have only one class of stock
- Submit Form 2553 and have the form signed by all the shareholders.
S Corp Shareholders’ Tax Liability
If you or any other shareholder do substantial work for the business, you are considered employees and therefore subject to Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and federal income tax withholding. It doesn’t matter if you are a corporate officer; as long as you perform a service for the corporation and receive payment, those payments are considered wages. And, bottom line, wages are taxable income, and must be reported on your and the shareholders’ personal income tax.
Unlike public companies, which pay out dividends to shareholders from their corporate income, S Corps pay out distributions—a share of the company’s net profit. C Corp dividends are subject to taxes and S Corp distributions are not. Where business owners get in trouble is when they try to pay themselves a miniscule salary and take their compensation in the form of a distribution to avoid paying FUTA and FICA payroll taxes on their income. The IRS and Social Security Administration are on the lookout for those trying to avoid payroll taxes, and if caught, your business will lose its S Corp status.
The IRS also expects you to pay yourself a “reasonable salary.” What’s considered reasonable is clearly dependent on your industry and the scope of your duties. To stay on the right side of the IRS, it’s a good idea to research average salaries for comparable positions and adjust your salary accordingly.
If the IRS decides you’re “substantially underpaid” for the services you provide, they can require adjustments be made to the income and expenses of both your tax returns and the corporation’s tax returns.
Finally, it’s important to make sure distributions to any shareholder (including yourself) don’t exceed that shareholder’s stake in the business. Any distributions above the shareholder’s stock basis are considered long-term capital gains and are subject to taxes.
You can still take advantage of the tax-free distributions of a S Corp, as long as you pay yourself a reasonable salary. Make the salary on the low end of what’s reasonable, and you’ll reduce your personal tax rate, plus enjoy the benefits of any distributions, while still keeping the IRS from taking your business to task over unpaid taxes.