An S corporation is often viewed as a hybrid business form, since it is a small corporation that is taxed in a manner similar to a partnership or another non-corporate business entity. If you form an S corporation instead of a conventional C corporation, you may need to pay fewer Social Security and Medicare taxes. This is because the owner and other key employees may not only work for the corporation but also hold shares in it. They can be compensated through shareholder distributions, which are not subject to Social Security and Medicare taxes. However, a shareholder will be considered an employee for tax purposes if they perform significant services for the corporation.
More often than not, an S corporation has only one owner. This gives them the authority to set salaries for employees of the corporation, including their own salary. Recently, the IRS has grown sensitive to the potential for manipulating the tax laws in this area, so they have applied extra scrutiny to S corporations.
Paying Reasonable Employee Compensation
Some owners of S corporations have arranged for the corporation to pay them no salary as an employee at all, which meant that the corporation did not pay the appropriate amount of payroll taxes. The federal government has lost billions of dollars as a result. The actions of these S corporation owners violated the rule that a shareholder who is an employee must receive reasonable employee compensation for their services to the corporation, separate from the distributions that they receive. This compensation is subject to payroll taxes. If the records of your corporation show that the owner is receiving minimal or no salary, you are likely to face an audit.
The consequences for improperly evading employment taxes can be severe. In addition to paying the employment taxes that went unpaid, the corporation may be ordered to pay penalties equal to the size of the unpaid employment taxes and further penalties for negligence. This can occur whenever the IRS determines that an owner’s salary was unreasonably low in view of the services that they provided to the S corporation. The IRS has the authority to reclassify distributions as salary to the extent necessary to make up a reasonable salary for the employee.
The Pass-Through Deduction Under the Tax Cuts and Jobs Act
Under the Tax Cuts and Jobs Act, owners of S corporations and many other business entities may receive a pass-through deduction of up to 20 percent of their net business income. There are many complex criteria and limits for this deduction, and you should read more about it here to determine whether you may qualify. Wages that owners of S corporations receive as employees count for the purposes of the pass-through deduction. This can make it advantageous to increase the salary that the owner is paid. The owner will receive the optimal benefit from the deduction if they pay about 28.6 percent of the business income as salary to employees. Since the pass-through deduction is capped at 20 percent of business income, and employee wages can be deducted from business income, paying a greater amount as salary reduces the amount of the pass-through deduction.