4 Ways S-Corp Employee Compensation Can Create Tax Issues

For many S-corporations, the shareholders of the company are also employees. In fact, with a majority S-corps, there is only one shareholder who is also the company’s key employee. As a result, there are various opportunities for an S-corporation to find itself in trouble with the IRS with regard to employment taxes.

4 Reasons Employee Shareholder Compensation Can Get You in Trouble With the IRS

Why do S-corporations with shareholders who are also employees sometimes find themselves in trouble with the IRS? Here are four reasons:

  1. When an employee of an S-corporation who is also a shareholder receives compensation, Social Security and Medicare taxes must be paid. However, when that same employee-shareholder receives a distribution from the company of earnings or profits, those taxes do not have to be paid. This clearly creates an incentive to make distributions rather than increase compensation.
  2. Ultimately, the decision for how much to pay an employee rests with the company’s officers and directors. When these parties overlap, and when there are tax benefits associated with keeping salaries low and distributions high, the temptation may be greater to pay an unreasonably low salary to an employee shareholder.
  3. The IRS rules, however, require that an employee be paid reasonable compensation before any shareholder distribution can be made. Failing to abide by these rules can result in significant tax problems.
  4. The IRS is reportedly focusing more of its attention specifically on S-corporations in an attempt to cut down on the number of small businesses that are unreasonably compensating shareholder employees in an effort to avoid payroll taxes.

What can happen if the IRS decides that your compensation is unreasonably low? The IRS can re-characterize the distributions that were made to you as a shareholder as salary. It can then require that you pay employment taxes and penalties that can add up quickly.

If you are facing an employment tax issue with the IRS, it is important to act quickly. We encourage you to contact us today for more information at 800.721.7054.

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