One of the beautiful things about forming a corporation – whether it’s a normal for profit corporation or a social enterprise like a benefit or flexible purpose corporation -is that your business can elect to be taxed as something we’ve talked about before, an “S-Corp.”
Because of the favorable tax treatment, though, the IRS is always on the lookout for those businesses that take the benefit too far.
Typically, an owner of stock in an S-Corp also performs services for the company making him or her, in addition to an investor in the company, an employee of the company in the eyes of the IRS.
Since S-Corps don’t pay business taxes, the taxman collects their portion from two sources: income taxes on distributions and payroll taxes on the salaries paid (Social Security Tax, Medicare Withholding, Unemployment Taxes, etc.).
So the obvious incentive for “enterprising” entrepreneurs is to just take distributions, and skip taking a salary.
That way, they can avoid all those pesky “extra” taxes.
Well, turns out the IRS doesn’t like that. They want their slice… and you can get in a LOT of trouble if you don’t give it to them correctly and on time.
So what can a shareholder/employee of an S-Corp do to avoid locating themselves squarely in the cross-hairs of the IRS on this issue?
Well, you have to be sure to pay yourself a “reasonable” salary before you take distributions (which includes paying the appropriate employment taxes on that salary).
What’s a reasonable salary, then, you might ask… well, turns out it’s not rocket science to figure out, and if the IRS comes after you – this is the resource they’ll look to to peg what’s a “reasonable” salary for what you’re actually doing.
Interestingly enough, it’s usually the shareholder/employees of professional S-Corps (CPA firms and attorneys) that try to say that their $15,000 per year salary and $125,000 annual distribution is “reasonable.”
Good try, guys, but now you’ll have to pay back taxes and penalties. Would have been cheaper to do it correctly in the first place.