Small “S” corporation owners: Watch your wages

Business owners who provide professional services dodged a tax bullet recently with the defeat of the federal Senate Bill 2343, which would have extended the application of existing payroll taxes to include tax on dividends paid by Subchapter “S” corporations to certain shareholders.

A small business which has elected to be taxed as an “S” corporation is a “flow-through” tax entity, which means that the net income (or loss) of the company flows through to the individual owners and is reported on the individual tax returns. In an “S” corporation, owners who also work for the company can take profits from the company and allocate those profits into two categories.

First, owners pay themselves W2 wages as compensation for services, which are subject to payroll tax. Any remaining profits can be characterized as distributions (e.g. dividends), which are not subject to payroll tax. While the calculation of self-employment payroll tax depends on a number of variables, in 2012 the savings could be more than 6% on the amount distributed as dividends.  

The IRS is concerned that some “S” corporation owners will set artificially low wages to take advantage of the savings and reduce their payroll tax obligations. IRS regulations therefore require that “S” corporation shareholders who provide employment-type services to the company they own pay themselves “reasonable compensation” based on market rates for similar jobs in the area. The IRS, however, does not maintain a specific schedule of reasonable wages for owners, which can leave the shareholder in a quandary as to how much salary is “reasonable.”

Perhaps because of the considerable gray area in determining compliance with the “reasonable compensation” requirement, the IRS continues be wary of perceived abuse in setting below market wages for “S” corporation owners. The most recent attempt to address this problem was Senate Bill 2343, which was narrowly defeated on May 16, 2012. The bill would have required certain shareholders in “professional services” fields such as health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services to characterize all of the profits they receive from the company as wages subject to payroll tax, eliminating the ability to distinguish between W2 wages and dividends for payroll tax purposes.

SB 2343 would have imposed this “new” tax only on small “S” corporations where 75 percent or more of the gross income of the business is “attributable to the service of three or fewer shareholders of such corporation,” a situation common in closely-held businesses where the shareholders actively work for the company. The tax would have applied to shareholders whose adjusted gross income is $250,000 or more (for married taxpayers), or $200,000 or more (for individual taxpayers).

Because “S” corporations are flow-through entities, company profits are allocated to shareholders and reported on the shareholders’ income tax return, regardless of whether the company distributes those profits in cash to the shareholders. As a result, if SB 2343 had been approved, one effect would have been that some “S” corporation shareholders would have owed payroll tax even if those shareholders had not been paid anything (an undesirable tax result known as “phantom income”).

Although the Senate failed to approve SB 2343, a similar revision to the tax treatment of “S” corporation shareholders has been proposed in the past and is likely to appear again in another future bill or IRS regulation. The IRS is likely to monitor potential abuses by owners designed to avoid or unreasonably minimize payment of payroll tax, making it important that “S” corporation shareholders pay careful attention to the characterization, as well as the amount, of their compensation and dividends.

Categories: Company Perspectives, Finance