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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.
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.