S Corporations and Salaries: An IRS Hot Button Issue

The IRS has stepped up its scrutiny of salary versus distributions with S corp employees.

By , J.D. USC Gould School of Law

An S corporation (also called a Subchapter S corporation) is a small corporation that has elected to be taxed much the same as a partnership by the IRS. An S corporation is a pass-through entity—income and losses pass through the corporation to the owners' personal tax returns. Many small business owners use S corporations. One of the biggest reasons is that an S corporation can save a business owner Social Security and Medicare taxes. However, this has become a hot button issue for the IRS.

An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes, as well as a shareholder. In effect, an active shareholder in a S corporation wears at least two hats: as a shareholder (owner) of the corporation, and as an employee of that corporation. This allows for savings on Social Security and Medicare taxes because such taxes need not be paid on distributions of earnings and profits from the corporation to its shareholders. Thus, to the extent they pay themselves shareholder distributions instead of employee salary, S corporation shareholder/employees can save big money on payroll taxes.

It's up to the people who run an S corporation—its officers and directors—to decide how much salary to pay the corporation's employees. When you are employed by an S corporation that you own (alone or with others), you'll be the one making this decision. In fact, 70% of all S corporations are owned by just one person, so the owner has complete discretion to decide on his or her salary.

Reasonable Employee Compensation Must be Paid

However, an S corporation must pay reasonable employee compensation (subject to employment taxes) to a shareholder-employee in return for the services the employee provides before a distribution (not subject to employment taxes) may be given to the shareholder-employee.

Unfortunately, many S corporation owners went overboard and had their corporations pay them no employee compensation at all, thus avoiding having to pay any payroll taxes. The IRS Inspector General found that in 2000 about 440,000 single shareholder S corporations paid no salary to their owners, costing the government billions in lost payroll taxes. As a result the IRS stepped up enforcement on this issue and audited thousands of S corps that paid their owners little or no salary.

If the IRS concludes that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can recharacterize the distributions as salary and require payment of employment taxes and penalties which can include payroll tax penalties of up to 100% plus negligence penalties. The IRS will do so if it concludes that the corporation paid the employee unreasonably low compensation for his or her services. For example, a CPA who incorporated his practice took a $24,000 annual salary from his S corporation and received $220,000 in dividends which were free of employment taxes. The IRS said that his salary was unreasonably low and that $175,000 of the dividends should be treated as wages subject to employment taxes. The court upheld the IRS's power to recharacterize the dividends as wages subject to employment tax. (Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d.

Impact of Tax Reform Law

The Tax Cuts and Jobs Act ("TCJA") which went into effect in 2018, further complicates the S corporation employee wage equation. S corporations remain an effective means to avoid Social Security and Medicare tax under the new law. However, the TCJA instituted a new pass-through tax deduction that S corporation owners can take advantage of. Starting in 2018, owners of S corporations and other pass-through entities may deduct up to 20% of their net business income from their income taxes.

You qualify for the 20% deduction only if your total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly). If your taxable income is greater than $207,500 (single) or $415,000 (married), you don't qualify for the pass-through deduction at all if you are involved in a personal service business, such as accounting, law, health, consulting, athletics, financial services, and brokerage services. If you're not involved in such a service business, your deduction is limited to the greater of (1) 50% of the W2 wages you pay employees, or (2) 25% of wages plus 2.5% of the cost of your business property (but the deduction may never exceed 20% of your business income).

The employee wages S corporation owners pay themselves appear to count for purposes of the pass-through deduction. Thus, in cases where the pass-through deduction is based on W2 wages, it is in an S corporation owner's interest to pay himself or herself more employee wages than under prior law when there was no pass-through deduction. Tax experts have calculated that 28.57% of business income should be paid as employee wages to maximize the pass-through deduction. Why not pay even more as wages? Paying more actually results in a smaller deduction because the total pass-through deduction may never exceed 20% of business income. Employee wages are a business deduction that reduces business income.

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