Shareholder Distribution vs. Payroll

S-Corporation officers are presumed employees and must receive compensation.

The owners of a S-Corporation (S-Corp) are the shareholders, as in any corporation. However, the S-Corp pays its owners distributions instead of dividends. S-Corp officers are also usually legally considered employees of the S-Corp and thus are required to receive appropriate wage compensation. Such distributions and wages have different tax considerations and consequences.

S-Corporation Taxation

An S-Corporation does not pay any separate corporate income tax. The law provides for a direct passing of corporate profits and losses to the shareholders. Shareholders can be paid money from the S-Corp by distributions of corporate income and by wages. Any money received as a distribution is subject to income tax on the part of the individual shareholder. However, money received as wages is subject to all payroll taxes, including Social Security, unemployment insurance, disability insurance plus income tax. Therefore, money paid as a distribution is taxed less than money paid as wages.

Employee Status

The IRS regulations contain a presumption that all S-Corp officers are employees of that S-Corp. This regulation has an exception if the officer performs no work or services for the S-Corp -- or it can be demonstrated that the work or services are only minor in nature -- and the officer receives no compensation. For example, a monetary payment for attendance at regular meetings would make the officer an employee. All officers not meeting the exception are employees and the law requires them to be paid a reasonable wage.

Reasonable Wage

IRS regulations do not specifically define what a reasonable wage is. However, there are available guidelines. Key factors include: the experience, education and skills of the officer-employee; the nature and importance of the work duties; the amount of time and effort invested in the work. If non-officer employees in the same company or other companies with similar job factors are paid more than the officer-employee, there is a doubt of reasonable wages. Such a doubt can cause an IRS audit and possible tax penalties.

Payment of Distributions

Payments can also be made to S-Corp shareholders as declared distributions of corporate income, which are not subject to payroll taxes. A shareholder who is considered an employee cannot legally be paid only or mostly by such distributions. Even where there are recognized reasonable wages, distributions must follow some guidelines, such as: distributions should not be paid if the S-Corp is operating at a loss; distributions must be made to all shareholders, in proportion to their share of ownership; and distributions should be authorized and documented in the corporate minutes.

References

• Internal Revenue Service: Fact Sheets: 2008-25: Wage Compensation for S Corporation Officers
• QBalance.com: QuickBooks Information Center: Business Knowledgebase & Resources: Human Resources and reasonable compensation: Reasonable Compensation
• Mary W. Simmons, CPA: Publications: IRS Turns Its Attention to S Corporation Returns Lowballing Shareholder Compensation