Often, S corporation shareholders serve as officers, directors and employees of their corporation, as S corporations have a small number of shareholders because they are usually family-owned and/or closely-held businesses. This may present a choice for these individuals regarding how they wish to receive compensation, either as salary and/or as income with respect to their stock ownership in the S corporation.
Salary payments are deductible by the corporation as a viable business expense (with the deduction reducing the net income or increasing the losses that pass through to the shareholder as well) and the same is includible in the employee’s gross income. These wages are of course subject to various federal and state employment taxes (FICA, Medicare, etc.) imposed on both the employer and the employee. The remaining net income/loss after deducting the salary expense of the shareholder/employee are free of such payroll taxes but are included in the income of the shareholder/employee. Thus, the shareholder/employee is likely to be tempted to keep his salary from the S corporation relatively low in order to save employment taxes. The IRS will likely be looking closely at salary compensation payments to shareholders in S corporations for these reasons.
As noted above, there may be a temptation by these shareholders/employees or their advisors to undervalue their wage compensation while being allocated larger net income attributable to their stock ownership in an attempt to reduce their employment tax (payroll tax) liability since the income allocated to a shareholder is not subject to employment (payroll) taxation. Thus, the IRS will scrutinize any wage compensation to a director, officer or employee shareholder that may be deemed too low for the work performed. A shareholder/employee certainly should not be permitted to evade employment taxes (FICA, Medicare taxes, etc.) by characterizing all of an employee’s remuneration as something other than “wages.”
There have been many reviews by the IRS and the judiciary of such wage avoidance situations and courts have deemed the income allocated to the shareholder/employee as wages, or a portion thereof if the wage compensation is not reasonable. This can also lead to court orders to pay not only FICA deficiencies, but assessed interest and penalties incurred.
S corporations and their owners should be prudent in setting up their compensation plans to ensure that reasonable compensation is paid to an officer, director or employee shareholder so as to avoid any scrutiny (likely to continue year over year, potentially via audit) by the IRS regarding employment (payroll) taxes.
Furthermore, note that this blog is not to be construed as providing legal advice to the readers, and should this blog be construed as an advertising solicitation, “the choice of a lawyer is an important decision and should not be based upon advertising alone.”
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*This post was originally published on March 31, 2016
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