S corps are corporate anomalies, a hybrid between a flow-through sole proprietorship (or partnership) and a typical C corporation.
(article continues below)
They are very attractive to entrepreneurs and small business owners who want to access corporate benefits while maintaining the feel of a more simple business model.
But before you buy into the idea that you can have your cake and eat it too, the IRS wants to remind you that even S corps have limitations, especially when it comes to the issue of shareholder and employee compensation.
The distinction between dividends and salary is at the crux of the IRS' complaint against some S corp business owners. Since income flows through the S corp to shareholders, business owners usually want to maximize dividend income to avoid paying FICA and employment taxes. The IRS, on the other hand, says not so fast – and has gone out of its way to curb the practice.
The IRS Takes the Reins
In the past, when you applied for S corp status the IRS simply notified you that your request had been approved. But with the dividend/salary issue becoming a bigger problem, the IRS has modified its notification to feature a discussion of the "tax obligations" that are involved in the payment of compensation to shareholder-employees. The actual notice reads, "When a shareholder-employee of an S Corporation provides services to the S corporation, reasonable compensation generally needs to be paid. This compensation is subject to employment taxes."
Failure to live up to the IRS' "reasonable compensation" standard has consequences. If a shareholder-employee does not designate a reasonable amount of income as salary, the IRS will "recharacterize" a percentage of dividends as salary for tax purposes.
The big question mark is deciding how to calculate reasonable compensation. According to IRS standards, salaries and wages must reflect economic realities. In other words, you can't randomly decide to pay yourself an annual salary of $100 and call it reasonable. Instead, you will be expected to establish your salary level based on normal salary review criteria including training, experience, duties, time, responsibilities, and other factors. If the business has other employees, their salaries can also be used to determine how much of the shareholder-employee's income has to be designated as wages.