While the C corporation is the business structure of choice for the Fortune 500, many business owners have found success by adopting C corp’s smaller variation: the S corporation. If you’re starting a new business or thinking about restructuring your existing business, choosing S corp status may provide some valuable advantages. With an S corp, you can:
For many business owners, the chief benefit of S corp status is the opportunity to skip corporate income tax and pay only taxes on wages and distributions of profits through their personal tax returns. However, this ideal scenario also means closer IRS scrutiny, particularly concerning compensation for shareholders who are also employees.
Whether your business is currently an S corp or you are thinking about converting to this structure, it’s important to consider how you will receive your income. As both a shareholder (owner) and employee, your compensation can come in two forms: a regular salary and the distribution of profits through timely distributions. The challenge regarding shareholder-employee compensation lies in the fact that payroll and distributions are taxed differently.
The way your income is categorized affects the amount of revenue the IRS receives. For example, shareholder-employees pay a lower tax rate on their distribution income than on their salary. On the other hand, a business can expense money by claiming a deduction on its payroll expenses bringing down taxable profit, but not on its distributions which don’t affect profit. But receiving a disproportionate amount of compensation as either one or the other may violate IRS rules – potentially triggering an audit that could lead to a reclassification of your wages, an obligation to pay back taxes, and financial penalties.
To avoid the tax consequences of shareholder-employee compensation that the IRS deems “unreasonable,” it’s essential to establish how shareholder-employees’ salaries and dividends are determined using a transparent process. These decisions should be made in an official shareholder meeting and documented in the meeting’s minutes in case of an IRS audit.