Many small business owners use S corporations.
As a pass-through entity, an S corporation is set up so that income and losses pass through the corporation to the owners’ personal tax returns.
But if the owner performs more than minor services for the S corporation, they essentially become an employee as well as a shareholder.
The owner then saves on Social Security and Medicare taxes because taxes don’t have to be paid when distributions of earnings and profits go from the S corp to shareholders.
In the past, a number of S corp owners would pay themselves shareholder distributions instead of an employee salary, or a very reduced salary.
This loophole allowed for huge savings on payroll taxes.
Why S Corp Owners Need to Take a Salary
The IRS caught on to this “gray area” strategy, and realized that they were losing billions of dollars in payroll taxes. Ever since, S corporation owners are under much closer scrutiny in payroll.
It’s required by law that an S corporation pay reasonable employee compensation (which are then subject to employment taxes) to a shareholder/employee.
This compensation is in return for the services provided before a distribution (which aren’t subject to employment taxes) is allowed to be given to that shareholder/employee.
Such services are typically provided by an owner, and usually those services are what provide a large percentage of the business income.
Stiff IRS Penalties for Evading Payroll Taxes
The IRS has steep penalties in place for those who characterize S corporation income as shareholder distributions of profits and take a small employee salary.
If the IRS finds that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can recharacterize the distributions as salary.
They can then require payment of employment taxes and penalties which can include payroll tax penalties of up to 100% plus negligence penalties.
That would hurt.
Stay in compliance and off the radar of the IRS by taking a reasonable employee salary for your industry.