QUESTION on S Corporation Taxes for Employees and Shareholders
There are three of us that would like to start a concrete masonry business. We are looking at an S Corporation, thinking this set up may fit our needs. We want to make sure that all three have equal ownership and profits. However, two members will be doing the work and the third is a business associate only. So how do the two shareholders receive a salary while the third only once a year receive a stakeholders portion?
And, how does the tax work especially for the two people receiving a salary on top of the third person only receiving an annual payment on any profits?
As mentioned in the article S Corporation vs. LLC: Which Structure is Right for Your Business.
In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings.
The S Corporation’s pass-through income offers an employment tax advantage over the other legal structures such as sole proprietorships, partnerships and LLCs. Given this potential tax savings, there is a strong motivation for shareholders-employees of S Corporations to minimize compensation in favor of distribution.
The issue of wages and compensation between shareholders vs. employees for an S Corporation is very tricky – and one that is closely watched by the Internal Revenue Service (IRS). In fact, the IRS has challenged in court what it deems as abuses of the potential employment tax savings in S Corporations. It is best to talk to a tax advisor to get advice on your situation and reduce potential liability exposure.
IRS defines an employee as:
The definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code include corporate officers. When corporate officers perform a service for the corporation and receive or are entitled to payments, those payments are considered wages.
The fact that an officer is also a shareholder does not change this requirement. Such payments to the corporate officer are treated as wages. Courts have consistently held S corporation officers/shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, compensation are subject to federal employment taxes.
IRS has issued Revenue Ruling 74-44, which addresses the characterization of “dividends” distributed by an S corporation to its shareholder. It holds that “dividends” paid to shareholders will be recharacterized as wages when such “dividends” are paid to shareholders in lieu of reasonable compensation for services performed for the S corporation. Some of the court cases that backed this IRS ruling include Joseph Radtke v. U.S., Spicer Accounting v. U.S., Joly v. Comm., and Veterinary Surgical Consultants v. Comm.
I also suggest you read this IRS letter on wages and compensation for employees and shareholders of an S corporation:
.. If a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services.
An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.
The tricky part is how “reasonable compensation” is defined. IRS does not provide specific guidelines for reasonable compensation, but lists down some factors considered by courts in determining reasonable compensation:
- 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
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Read the article S Corporation Reasonable Compensation Tips for ideas on how to set a compensation structure for your S Corporation.
Note though, that savings on not paying the self-employment tax is not automatic. The author of the book LLC vs. S-Corp vs. C-Corp: Explained in 100 Pages or Less states that:
The big benefit of S-corp taxation is that S-corporation shareholders do not have to pay self-employment tax on their share of the business’s profits.
The big catch is that before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary). This salary will of course be subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”
To avoid any legal entanglements with the IRS including penalties, please consult a tax professional or financial advisor to help ensure that your treatment of payments to the parties involved in your S corporation adheres to the IRS tax guidelines. I also suggest you read the following books:
- Practical Guide to S Corporations (6th Edition)
- How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners
- Kahn, Kahn, and Perris’s Taxation of S Corporations in a Nutshell
- Taxpayer’s Comprehensive Guide to LLCs and S Corps
- How to Set Salary of Partners in S Corporation
- S Corporation Reasonable Compensation Tips
- Advantages of S Corporations
- Setting Up a Limited Liability Company and S Corporation in California
- Forming an LLC and Electing to be Taxed as an “S” Corp