Financial Facts for Running Your Business
All the Facts You Need to Know About S-Corporations
by Kenneth Cerini, CPA, CFP, DABFA
For years S-Corporation owners have utilized shareholder distributions as a way of pulling profits out of their business. Too often, however these distributions came in lieu of salary.
Taxation of distributions:
S-Corporations provide their shareholders with the benefit of a single layer of tax. They are pass through entities, so any earnings of the corporation pass through the corporation to the individual shareholders where they are ultimately taxed. As a result, the shareholders personally pay tax on the profits whether they are distributed or not. Therefore, distributing these profits does not provide for any additional taxation. This differs from a regular or C-Corporation, in that the C-Corporation is not a pass through entity. Profits, therefore, are taxed at the corporate level and not the individual level. When profits are ultimately distributed to shareholders, they are transferred as dividends, subject to tax at the personal level … double taxation. As part of the 2003 Economic Growth and Tax Recovery Act, the tax on dividends was lowered to 15% and 10% (dependent on income levels), however there still remains two levels of taxation.
Taxation of Wages:
The taxation of wages is substantially the same whether an entity is an S-Corporation or a C-Corporation. The corporation gets a deduction for the wages paid, providing such wages are reasonable, and the shareholder receiving the wages is taxed individually for those wages. In a C-Corporation this effectively eliminates the double taxation because the income is transferred from the corporation to the individual shareholder. This is not the case in an S-Corporation however, since the S-Corporation has only 1 level of taxation.
In addition, wages are subject to other forms of taxation, namely Social Security, Medicare, workers' compensation, and Federal and state unemployment. This could result in additional taxation of some 20% or so.
Distributions in Lieu of Wages:
As a result, shareholders generally benefit from having monies paid to them in the form of distributions as opposed to wages. While this is not in compliance with IRS regulations, many small corporations, nonetheless, have employed this strategy over the years. The IRS has always maintained its ability to recharacterize S-Corporation distributions to wages, when they believe that wages paid to shareholders are too low. And in fact, court cases have supported the IRS' position of recharacterization. In the past, however, it was not a high priority for the IRS, so the practice went unchecked.
The IRS' Renewed Interest:
The IRS believes that this practice has gone on too long, and they have recently expressed an interest in challenging such cases in the future. Where a shareholder provides services to an S-Corporation, and such services are instrumental in the corporation's operations and profitability, the IRS will be looking to see that the individual received reasonable compensation for such services. If the shareholder did not, and the shareholder received distributions of profits, the IRS will consider challenging the status of these distributions in an effort to reclassify them as salary.
During 2002, the IRS performed a study, whereby 84 S-Corporation cases were "judgementally selected" from a population of returns where income exceeded $50,000, but compensation to officers was below $10,000. The results were staggering. Average shareholder compensation was $5,300 while average distributions to shareholders were $349,323. The large disparity between these amounts suggests a potential underreporting of salaries.
Conclusion:
In order to avoid the taxes, penalties, and interest associated with a recharacterization of distributions to wages by the IRS, it is going to be imperative for S-Corporation shareholders to pay themselves reasonable compensation before any distributions are taken. The issue is going to come down to exactly what is reasonable compensation, and how is it determined. The goal will be for shareholders to find an amount they can live with and that will also appease the IRS.
Kenneth Cerini, CPA, CFP, DABFA is the Managing Partner of Cerini & Associates, LLP, a full-service accounting and consulting firm located in Suffolk County, NY. The firm specializes in providing in-depth business advisory services to small business and non-profit organizations. For additional information visit them on the web at www.ceriniandassociates.com.
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