Written by: Tina Powell, CPA

As a shareholder of an S Corporation, you may think that you can just take the money you need as dividends.  That is somewhat true, but like all tax laws, there is a gray fuzzy line that shouldn’t be crossed.

The advantage of an S corporation over an LLC or sole proprietorship is that a shareholder’s share of the company’s net income is not considered self-employment earnings and therefore is not subject to payroll taxes or self-employment tax.  However, if a shareholder provides services to the S Corporation, they must receive an adequate or reasonable amount of compensation. The compensation is deductible, but is subject to Social Security Tax, Medicare Tax and Federal and State Unemployment Taxes.  So in an effort to minimize these taxes, owners tend to minimize compensation.  The IRS has been pursuing and winning cases of perceived abuse of inadequate compensation in favor of dividend distributions to shareholder-employees, so it is important to ensure that you can substantiate “reasonable compensation.”

The IRS looks at many factors in determining reasonable compensation including the following: 

  • Training and Experience                                               
  • Duties and Responsibilities
  • Dividend History                                              
  • Time and Effort Devoted to the Business
  • Timing of Bonuses                                          
  • Payments to Non-Shareholder Employees
  • Comparable Compensation Similar         
  • Use of a Formula to Determine Compensation
  • Businesses Pay for Similar Services         
  • Compensation Agreements

The key to defending your claim to reasonable compensation is to document all research to support the amount of compensation.  The IRS has the authority to reclassify dividends, distributions or payments to the shareholder-employee, including loan repayments, as compensation if it deems compensation is inadequate or unreasonable.  The courts have held that reasonable compensation is one of fact, determined on a case-by-case basis.  So if you have your support or documentation, you are in a better position to avoid reclassification.

The S corporation entity form provides planning opportunities to avoid payroll taxes or self-employment taxes.  With the increase in Medicare tax as a result of Obama Care scheduled to begin in 2013, this may represent a larger opportunity.