Unlike a partner in a
partnership, the shareholder’s share of Subchapter S corporation taxable income is
not subject to self-employment tax. However, if the shareholder performs
services for the corporation, the shareholder must be paid a reasonable
wage (subject to FICA, FUTA, and state unemployment taxes).
Reasonable Wage For Services
The temptation is to pay little or no wages
to the Subchapter S corporation shareholder for the sole purpose of reducing Social
Security and other employment taxes. This issue was addressed by the
7th Circuit in the case of a lawyer who incorporated his law
practice and elected to be a Subchapter S corporation. The lawyer received no wages
during the year but was able to take distributions whenever the
corporation had funds available.
When the IRS is successful in
re-characterizing distributions as wages,
the Subchapter S corporation is subject to all of the employment taxes along with
penalties and interest for failure to deposit the taxes, and possible
failure to file Forms 940 and 941.
Some factors considered by the IRS and
courts to determine if shareholder compensation is "reasonable":
• Compensation paid for similar positions
in other companies.
• Shareholder’s background and experience.
• Shareholder’s contribution to profit making.
• Time spent performing services.
• General economic conditions.
• Salary paid to other employees.
• Employer’s financial condition.
• Compensation paid in prior years.
• Comparison of compensation to distributions and retained earnings.
Proposed Regulation §1.1366-3: In
addition to challenging compensation paid to shareholders, the IRS will
challenge compensation paid to members of the shareholders’ families. If
the compensation for services or for use of capital is not reasonable, the
IRS will make an adjustment. This adjustment will also carry through to
the recipient of the compensation.
