S-corporations, sometime when you were setting up your business, you chose, or someone advised you to choose S-corporation as your business form. One advantage is they avoid the “double taxation” of the C-corporation; the government does not usually tax S-corporations. The S-corporation passes income through to you, a shareholder, and you pay the taxes on your share. Another advantage is that only part of the income passes through to you as self-employment income, reducing the amount of self-employment tax you pay. It is that second advantage where the audit risk lies. Get greedy and the IRS will slaughter you.
Hogs will be slaughtered: The IRS says shareholder-employees, officers, directors, and other shareholders who work for the company, must pay themselves wages or salary. If you work in and on your business, and that business is an S-corporation, you are a shareholder-employee who needs to take pay.
The fastest way to an audit is to leave Compensation of Officers, line 7 Form 1120S, blank. The IRS assumes no one works free. If you are the only shareholder-employee of an S-corporation, your salary goes on line 7. If there is more than one shareholder-employee, someone’s salary must go on line 7.
Furthermore, the S-corporation must pay its “owners” a reasonable salary. “What is a reasonable salary for my business?” is a legal question. Non-attorney tax professionals can’t answer it, but we can discuss what the IRS looks at in a tax audit. Moving along…
Dividends verses Salary & Wages: The big difference between dividend income and salary income is that the government places an additional 15.3% self-employment tax on wages & salaries but not on dividends. S-corporation shareholder-employees often shave their salaries to the bone in order to avoid self-employment taxes. This strategy can backfire. If the IRS decides your company did not pay you enough salary, they can reclassify dividends as salary, which results in more taxes, penalties and interest. It’s very important for you, the S-corporation shareholder-employee, to get your salary right.
So how do you figure out what a reasonable salary is? Ask yourself what somebody else, who is working in a similar job in the same industry, would receive for that job:
- How many hours do you work?
- How much experience to you have?
- What is the average local rate of pay for that job?
- How much education do you have?
- What do you pay other individuals doing a similar job in your company?
- Is your work primarily in the office? Or do you work in the business as well?
- Are there other employees capable of managing the business for you?
The IRS considers a salary reasonable if someone, who was not a shareholder, would do the same job for the same pay.
You cannot decide to take no salary. The IRS assumes no one works free.
You cannot decide to work for less than minimum wage. E.g. AZ current minimum wage is $7.35/hour, therefore if you work an average of 40 hours a week, 52 weeks out of the year, an annual salary below $15,288 is not enough.
You cannot decide to pay a large salary merely to increase business expenses. If you pay a million dollar salary to someone, when a $150,000 salary would be the norm, you will get in trouble. In this case, you should ask, “Would an outside investor pay this much for this particular employee’s job skills?”
Other factors in what is reasonable salary include:
- What is the size of the company (small, medium, large)?
- What is the character of the company (upscale, middle-class, humble)?
- What is the condition of the company (doing well, doing OK, barely making it, losing money)?
- What are general economic conditions like (booming, cruising along, lousy)?
- How complex is the company (complicated, has a few twists, simple)?
- How do wages & salaries compare to Gross Income & Net Income of the business?
- What is it like to live where you do (lower or higher cost of living, uncomfortable climate, nice scenery, many recreational activities, other specific local perks or downsides)?
An auditor may focus on just one of these factors; you should consider all of them.
Reasonable salary may also be influenced by how much money the company is making. A lower salary in a company barely scraping by may be OK, but not in the case of a well-run company making lots of money.
Return on investment (ROI): ROI is roughly how much you get out (dividends, not wages & salary) given how much you put in. The IRS may also look at ROI. If the ROI for a given type of business is 10%, then dividends paid to the extent ROI is a lot higher than normal may also increase audit risk.
60/40 Split: When the officer is the sole employee of the company, some tax professionals think paying more dividends than wages increases the chance of an audit. Although the Tax Court has occasionally ruled in favor a shareholder-employee taking a salary far less than their dividends, it is usually NOT the case. Besides, you would have to go through the entire IRS audit/appeals process to get to Tax Court to argue your case-that costs time & more money. Therefore, many tax professionals recommend a split of 60% wages/40% dividends. Note: Art & Business Consulting LLC is NOT recommending the 60/40 allocation of salary/dividends or any other specific amount.
Note: When there is more than one shareholder of an S-Corporation, the S-corporation should pay dividends in proportion to the amount of stock held by the shareholders. Problems happen when one or more shareholders pay their bills directly out of the company accounts. If the S-corporation classifies those payments as distributions, then the IRS may say the company has different “classes” of stock, which is not allowed under S-corporation rules; the company will lose its S-corporation status. S-corporations do not usually pay taxes, but when a company loses its S-corporation status, it becomes a C-corporation. C-corporation income is taxable at the corporate level too, and shareholders still have to pay their taxes as well.
Note: Usually an S-corporation shareholder-employee works for the company throughout the year, therefore the S-corporation pays shareholder-employee throughout the year. Payroll taxes forms and payments are due throughout the year too. S-corporation shareholder-employees should NOT decide how much the company pays them at the end of the year, as the IRS assesses penalties and interest on payroll taxes and forms filed late.
Note: When officers of an S-corporation discuss wages & salaries, the secretary should record those discussions in the minutes of the corporation.
FYI: The state of Arizona requires companies pay wages at least twice a month.
Other Advice: To avoid confusion between business and personal income & expenses, as well as shareholder payment classification issues, do not mix (commingle) personal and business income or expenses. Have separate business and personal bank accounts. Do not pay personal expenses out of directly out of business accounts. Write checks to pay your wages and dividends from the business account, deposit those funds into your personal account, then pay personal expenses out of a your personal bank account. Although nothing in the tax code specifically prohibits commingling of funds, commingled records make auditors drool, which is never a good sign.
When an S-corporation is losing money, an S-corporation may pay less. Be sure to create minutes, which document the changes in pay including an explanation of why a salary was increased or decreased.
Taking a salary, when the business is losing money increases the S-corporation’s losses. e.g. In a year where the company loses $10,000, if your salary is $10,000, then with the $765 employer portion of self-employment taxes the company loses $20,765. Whether you can deduct any part or all of that $20,765 in losses, depends on whether you have “basis” in your company. The discussion of basis is beyond the scope of this document.
The Bottom Line: There is no hard and fast rule as to what a “reasonable” salary is. In summary you are a shareholder working in or on your S-corporation, whether you are an officer or not, you
- must take a salary
- that salary should be at least minimum wage
- that salary probably should be more than dividends paid
- in addition, taking into account things like that your company’s character & condition, the business location & general economic conditions, your salary should be similar to what somebody else would make given similar experience in the same industry.
If you need a specific answer to this question, like “take X amount as salary and the Y as dividends,” you should consult your attorney for this specific advice. Art and Business Consulting LLC is NOT engaged to practice law.
Call us before the IRS calls you. Small Business and taxation are our business. If you have question about S-corporation taxes or other matters, Please give Art & Business Consulting a call. We would love to engage you as a client.
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