In working with business owners for many years, I’ve seen just about every variation possible when it comes to owner (shareholder) compensation verses distributions or draws. According to the IRS, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” In other words, the IRS considers no or low salary to a shareholder who is also an officer, and active in the business, an attempt to evade payroll taxes.
The penalty for failing to pay payroll taxes is 100% of the taxes owed, and the IRS is made aware of this when the S corporation files a tax return that reports little or no compensation to its shareholder/officer. The IRS can and will go after the corporation and the shareholder to collect payroll taxes on officer compensation. In determining if the shareholder evaded payroll taxes, the IRS will consider the following:
- Did the officer/shareholder provide substantial services? An officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive any remuneration is not considered an employee of the corporation. Therefore, to determine if the officer is an employee, it is important to look at the services the officer performed.
- Is the compensation reasonable? Zero pay, or unusually low pay, that is not justified by services performed are examples of unreasonable compensation. Several factors determine reasonableness of compensation: the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid; the prevailing general economic conditions; comparison of salaries with distributions to shareholders; the prevailing rates of compensation paid in similar businesses; the taxpayer’s salary policy for all employees; and, in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years. The IRS will ask, “What did the shareholder/employee do for the S corporation?”
As you can imagine, documentation is the key for taxpayers to justify their position if the IRS questions payments to shareholder/employees. Have well-drafted employment agreements; use a consistent approach each year to determine pay and bonuses, etc. By doing so, you can show that compensation plans were adopted in good faith, and the payments are in fact reasonable.