The attraction of electing S corporation status is well-known
among entrepreneurs, but there's a potential problem you may
run into if your business is organized as an S corp that you may
not be aware of. IRS auditors are paying very close attention to
the salary that the owners of S corps pay or don't pay
themselves.
As you know, S corporation income, losses, deductions and
credits "pass through" the business to the owners, to be
reported on their individual tax returns. While distributions from
the corporation are not subject to FICA withholding, the S corp
owner is required to withhold FICA taxes--which amount to a
whopping 7.65 percent on the first $87,000 in salary he or she
earns in 2003.
The problem, as the IRS sees it, is that some S corporation
owners may be tempted to give themselves artificially low salaries
for the services they perform, and thereby reduce the amount they
owe in Social Security and Medicare payroll taxes. Instead, they
take distributions to make up for the shortfall.
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To avoid a problem with the IRS, be sure to draw pay that the
agency would consider a "reasonable salary," says CPA
Wayne Edmunds, associate professor of accounting at Virginia
Commonwealth University in Richmond and a member of the American Institute of Professional
Bookkeepers certification advisory board. How do you determine
what is reasonable? While there is no exact definition provided by
the IRS, it's a good idea to take into account the profit level
of your company, the amount of time you spend on the job and the
type of business in question, says Edmunds.
Pay yourself what you would normally pay someone from the
outside to do the same job, recommends Mark Luscombe, a principal
tax analyst with CCH Inc., a tax and business law information provider
in Riverwoods, Illinois. You can also check with a national
association in your industry to find out what types of salaries are
paid to executives.
Keep in mind that "salaries are more supportable,
especially when it comes to an audit situation, if they are
approved by your company's board, even if that board is
controlled by family members," Luscombe explains. "As
part of this strategy, be sure to set out salaries for the year and
the rationale for how you calculated those salaries."
The bottom line? If the IRS starts probing in this area and
determines you have disguised salary as distributions, beware. It
can reclassify them as salary and assess payroll taxes on the
distributions along with penalties and interest.
Great Falls, Virginia, writer Joan Szabo has reported on tax
issues for more than 15 years.