Are you a shareholder of an S Corporation?

S corporation earnings flow through to its shareholders and are subject to income tax; but neither these earnings nor amounts taken by shareholders as distributions are subject to self-employment taxes.  Sound like a win-win situation?  Be careful.  Taking significant distributions is one way to likely cause scrutiny by the IRS.  Shareholders who provide a service to the S corporation’s business should be compensated through a salary or wages, subject to employment taxes.  But, do some research when deciding the amount of shareholder’s compensation.  It is wise to keep it minimal, but reasonable.  Consider the shareholder’s duties and any special qualifications he or she may have. 

Another good way to avoid taking significant distributions (and possibly reduce scrutiny by the IRS) is to consider paying rents to any shareholders that own real estate which the company uses.  While rent income is taxable on the shareholder’s return, it is not subject to self-employment tax.  Please keep in mind that the amount of rents paid should also be reasonable. 

Remember, the IRS often looks at significant distributions taken by shareholders and many times will re-characterize them as wages if they appear unreasonable, which means paying payroll taxes on these amounts on top of penalties and interest.  Common red flags to the IRS include:  particular business codes which indicate service businesses (implies shareholders are rendering some type of service for which they should be paid a salary); as mentioned before, significant distributions to shareholders; and finally, zero or very low compensation of officers and/or shareholders. 

For further advice on this matter, please contact one of our tax professionals.

/posted by Amy Brown, CPA