If your business has elected S Corporation status with the IRS, you have differentiated yourself from your company by making the company a separate entity, or corporation. Therefore, when you (the owner/shareholder) perform services for your business as an employee, the IRS requires you to take reasonable compensation in the form of a wage that will show up on a Form W-2 at year-end. Then, as an S Corp shareholder, you are required to pay Social Security and Medicare taxes on your W-2 salary. However, the benefit of an S Corp is the amount of net income that is produced over and above the amount of the salary paid does not have the Social Security or Medicare tax applied thus saving tax dollars.
The IRS wants you to pay yourself a salary that you’d pay someone else to do your job for you. When determining what salary is adequate you must take into consideration the various items that determine fair and reasonable pay. Title of the position, duties of the position, time spent on the job, experience in the position, among other things. It can be up for interpretation, so check with your CPA and other financial advisers to make the best decision.
The biggest risk you can take as an S Corp owner-employee is to take no salary at all. It is relatively simple for the IRS to develop a report of 1120S returns with no owner’s compensation and net profits or distributions, which means it’s hard to hide from the IRS if you aren’t paying yourself a salary. This is a red flag for the IRS and creates an easy court case for the IRS to win if you happen to get audited.
In the case of an audit, the IRS will have an easy time having the courts side with them when no or too little compensation has been paid. After they win the case, the IRS will likely choose a salary for you that is more than you would have allocated for yourself, thus requiring more Social Security and Medicare taxes to be paid, not to mention steep penalties and interest which will make it extremely difficult to stay in business. Therefore it’s best for you to decide your own salary, pay yourself that salary and lessen the chance that the IRS will step in and decide it for you.
In closing, you can’t have the best of both worlds. You can’t minimize tax by becoming an S-corp and also not pay yourself wages through a W-2. By doing this you are completely avoiding Social Security and Medicare tax which is a slam dunk case for the IRS to win.
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