S Corporations and Taxes
The S corporation (S corp) is a special kind of corporation that passes corporate taxes through to its shareholders. Then, the shareholders report this income on their personal tax returns and pay taxes on their total combined income at personal tax rates.
How S Corporation Employee Pay Works
An S corporation officer (president, chief operating officer, etc.) is considered an employee and payments they receive for their services as an employee are considered wages. This person is also an owner/shareholder, but each of these roles is separate.
S Corp Officer Wages Must Be Reasonable
The IRS requires that distributions and other payments by an S corporation to a corporate officer must be treated as wages “to the extent the amounts are reasonable compensation for services rendered to the corporation.” This means the employee’s wages must be reasonable compensation, not cash distributions, payments of personal expenses, or loans. The wage payments to the officer must be made first, before other distributions.
Withholding From Pay
The business must withhold FICA taxes (Social Security/Medicare) and federal income taxes from employee pay and the business must pay its share of the FICA taxes along with other employment taxes, including unemployment tax and worker’s compensation. Here’s an example: Carol and John are 50/50 shareholders in an S Corp and they both work as employees in managing the business. Their net profit last year was $250,000. They would like to split the profits and take them as a distribution, to avoid self-employment tax, but since they work in the corporation, they must first take a “reasonable” salary.
How To Figure a Reasonable Salary
What does “reasonable” mean? To find a reasonable salary for an S corporation owner/employee, consider how you would find a reasonable salary amount for any new employee. The IRS guidelines suggest you look at the following factors to determine reasonable salaries for your corporate officers:
Training and experienceDuties and responsibilitiesTime and effort devoted to the businessDividend historyPayments to non-shareholder employeesTiming and manner of paying bonuses to key peopleWhat comparable businesses pay for similar servicesCompensation agreementsThe use of a formula to determine compensation.
Use Comparable Salaries To Back Up Your Salary Figures
Your ability to prove that officer salaries are reasonable will help keep you on the right side of the IRS when it comes time for them to review your company’s tax returns.
Medical Insurance for Corporate Officers
The IRS looks closely at payments to shareholders who own more than 2% of the shares in the company: The IRS calls them “more-than-2%-shareholders.” If your company pays health and accident insurance premiums for these employees, you must include them as taxable wages for the employee. Include these medical/accident insurance payments on the shareholder-employee’s Form W-2, Box 1, but not Boxes 3 and 5.
Deducting Officer Salaries as a Business Expense
Wage payments to S corp officers, including medical and accident insurance premiums, are tax-deductible to your company, in the same way as other types of employee expenses.
Reporting Officer Salaries to the IRS
Each year, when you complete the income tax forms for your corporation or S corporation, you must report corporate officer salaries if the corporation’s total receipts are $500,000 or more. You will need to use IRS Form 1125-E - Compensation of Officers, listing compensation for each corporate officer, along with information about the percentage of time devoted to the business and the percentage of stock owned by this officer.
