If you run your business as an S corporation, you’re probably both a shareholder and an employee. As such, the corporation pays you a salary that reflects the work you do for the business — and you (and your company) must remit payroll tax on some or all of your wages.
By distributing some of the profits in the form of dividends rather than salary, an S corporation and its owners can avoid payroll taxes on these amounts. Because of the additional 0.9% Medicare tax on wages in excess of $200,000 ($250,000 for joint filers and $125,000 for married filing separately), the potential tax savings from classifying payments as dividends rather than salary may be even greater than it once would have been.
IRS audit target
But paying little or no salary is risky. The IRS targets S corporations with owners’ salaries that it considers unreasonably low and could assess unpaid payroll taxes, penalties and interest.
What the average IRS auditor would rather that you not know is this:
There is no section of the Revenue Code that states compensation must be a certain percentage of income or assets. As you can imagine, this makes it difficult for the IRA to say you’re unpaid and for you to contend that your wages are “reasonable.”
To avoid this conflict, your S corporation should establish and document reasonable salaries for each position using compensation surveys, comparable industry studies, company financial data and other evidence. Spell out the reasons for compensation amounts in your corporate minutes.
How do you prove a salary is reasonable?
As we mentioned above, there are no specific guidelines for reasonable compensation in the tax code or regulations. Various courts which have ruled on this issue have based their determinations on the facts and circumstances of each case. Factors considered in determining reasonable compensation include:
Training and experience,
Duties and responsibilities,
Time and effort devoted to the business,
Payments to non-owner employees,
Timing and manner of paying bonuses to key people, and
Ascertain the right mix.
Do you have questions about compensation? We can help you determine the mix of salary and dividends that can keep your tax liability as low as possible while standing up to IRS scrutiny.
Remember that you don’t have to fight this IRS battle alone. You can click the link below to contact us with questions after you’ve read this post.
He is also a founding Board Member and Finance Director of the Fayette Pregnancy Resource Center and serves on the Board of the National Equal Rights Institute.
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