Tips on S Corporation Compensation

by | Dec 27, 2012

The IRS continues to challenge S Corporation shareholders regarding proper methods for paying themselves. That said, it’s critical that your S Corporation structure is set up appropriately and that compensation is paid and reported correctly. For example, in a recent court appeal case, an attorney was slapped with penalties and interest after failing to remit payroll taxes for his corporation—even though compensation was reported on a 1099-MISC and individual income and social security taxes were paid. This is a good example of why S Corps must ensure that payments are reported as compensation by December 31, 2012, and that appropriate tax deposits are made and payroll tax returns are filed.

In recent years, the IRS has also instituted a payroll audit program for profitable S Corporations. The program flags income tax returns reporting little or no W-2 payroll wages. The IRS is identifying more of these cases and assessing additional taxes and substantial penalties. The penalty, over and above any unpaid Social Security (FICA) taxes, frequently exceeds an additional 50% of the total tax liability—even if you paid taxes when you filed your individual return. The core issues being identified by the IRS are negligence in paying Social Security tax and making bi-weekly or monthly payroll tax deposit payments.

Avoid being flagged by the IRS by following these tips:

Things to Avoid:

  • Paying unreasonably low or no salary to shareholders who perform services for the S Corporation while the corporation is generating a profit.
  • Offering loans to shareholders.
  • Paying shareholders’ personal expenses with corporate funds.
  • Using Form 1099 to report shareholder compensation instead of a W-2.
  • Borrowing money (via vendor payables, bank loans, or increased credit card debt) and then paying shareholders a distribution or loan.
  • Making distributions more frequently than once per month.
  • Assuming that part-time work for the S Corporation excuses compensation payment requirements.

Things to Do:

  • Pay reasonable compensation to shareholders.
  • Document all loans to shareholders with a written contract that offer a reasonable interest rate and strict payment terms.
  • Document all compensation, distribution, and loan issues in corporate minutes.
  • Pay distributions to all shareholders on the same date in proportion to the ownership percentage.

Contact us at our office and speak with one of our professionals about what steps you can take to avoid a painful and extremely costly S Corporation payroll tax audit.

From our entire staff: Best wishes for a happy and safe holiday season!