As a shareholder of an S Corporation or a member of an LLC that is taxed as an S Corporation, if you perform more than minor services for the business, in addition to being a shareholder, you can be considered an employee of your business. A major benefit of this shareholder/employee arrangement is that the shareholder/employee can take a salary, while at the same time saving on Social Security and Medicare taxes on the remainder of the business’ earnings. These saving arise because any distribution that the shareholder/employee takes outside of and after his salary does not incur the standard payroll taxes. The shareholder/employee can, therefore, save himself a large amount of money that would otherwise go to taxes.
However, there is a caveat. While you have the ability to determine the salary you take, that salary must be reasonable based on your position in the business and the services you provide. Stated another way, you cannot be an employee and make no salary, only receiving distributions from the business.
Unfortunately, because many shareholder/employees take advantage of the system, the IRS pays close attention to and is likely to audit – as it has done in the past – S Corporations that pay their shareholder/employees little or no salary.
If after an audit the IRS determines that the shareholder/employee has attempted to avoid payroll taxes by taking only distributions, it can recharacterize the distributions as salary and require not only the payment of the unpaid employment taxes but also penalties. The IRS will also require back pay and penalties if it finds that the business paid the shareholder/employee an unreasonably low salary.
It’s a fact that you must be paid a salary, but how low is too low and what is reasonable salary? Unfortunately, the IRS has not offered guidelines as to how it makes the determination.
Done on a case-by-case basis, the IRS considers many factors, including:
- The duties performed by the shareholder/employee and the volume of business handled;
- The complexity of the business;
- Use of a formula to determine compensation;
- The ability of the shareholder/employee; and
- The company’s policy regarding pay for all employees.
Prior to taking a reasonable salary in order to avoid payroll taxes, your business should speak to both legal and tax professionals to advise you on the best course of action for your specific situation.