How the IRS Decides If a Tax Problem Exists Due to Shareholder Distributions and Compensation

Many small business owners in Norman and throughout the country opt to make an S-election, meaning they are an S-corporation and receive certain tax benefits as a result. Income from the corporation flows through to the shareholders of the company, rather than being taxed at the company level as well as the individual level. In many cases, the shareholders of the S-corporation are also officers or employees of the company. One tax problem faced by some people attempting to avoid self-employment tax is to pay themselves by taking distributions from the corporation as a shareholder rather than by paying themselves a salary as an employee. If the IRS deems that the employment compensation was not reasonable, problems can arise for the taxpayer.

How the IRS Assesses Reasonableness of Compensation

When the IRS looks to assess the reasonableness of compensation to determine whether or not a tax problem exists, it will consider the following:

  1. The employee’s qualifications
  2. The nature, extent, and scope of the employee’s work
  3. The size and complexity of the business
  4. Current general economic conditions
  5. How salaries compare with distributions made to shareholders
  6. Typical compensation rates paid by similar businesses
  7. The corporation’s salary policy for it’s employees
  8. The amount of compensation paid to the employee in various years

The IRS is looking to determine what exactly the shareholder/employee did for the company. If the business’s gross receipts derive mostly from services provided by the shareholder/employee, it should be treated as compensation and not a distribution. If the gross receipts came from non-shareholder employees, capital, or equipment, then it is reasonable to deem the funds as a shareholder distribution not subject to self-employment tax.

The IRS rules surrounding the self-employment tax are complex. However, they are very important to business owners throughout the country. Do you want to learn more? We encourage you to read our free guide, The Ultimate Survival Guide for IRS Problems.