Many smaller companies are designated as S corporations for tax purposes. Individual shareholders in S corporations may also work for the corporation and have a dual financial stake. Because of the unique tax treatment of an S corporation, owners who are also workers must be careful to set their wage amount at a reasonable level, comparable to market value.
Unlike regular C corporations, S corporations are not taxed directly on their operating profit. The financial operating results of an S corporation flow through to each individual shareholder. Each shareholder then reports their portion of the gain or loss on their own personal income tax return.
Distinction between wages and distributions
A shareholder in an S corporation who also works for the corporation pays employment taxes on wages. In contrast, a distributive share of corporate profit received as a shareholder is not subject to employment tax. Accurately distinguishing between wages and the distributive share of profit is crucial to minimizing the possibility of an IRS audit.
An S corporation can have up to 100 shareholders. Any number of shareholders may also work for the company. In some small S corporations, one shareholder may be the sole employee. The primary consideration in setting the appropriate wage level for a shareholder is identifying how much of the company profit is due to the work of the shareholder.
Industry wage statistics are available from a variety of sources. The U.S. Bureau of Labor Statistics provides wage data charts for a wide array of occupations and areas. However, statistics for a specific job in a specific area provide only a general overview. Other factors must be considered in deciding how much to pay as reasonable compensation.
The profit of an S corporation may result from the work efforts of employees who are not shareholders. The assets and machinery owned by a company may also contribute significantly to financial profit. When additional factors are at work in producing profit, it becomes easier to consider shareholder work effort as contributing less.
There is a potentially positive tax effect of income being classified as wages. The funding of most tax-deferred retirement plans depends of the receipt of income earned as wages.
Profitable companies are likely to undergo continuous change. Each year, you may need to reconsider how much of shareholder compensation to designate as wages. Contact a compensation consultant, like one at Fox Lawson & Associates, A Division of Gallagher Benefit Services Inc., for objective assistance in determining the appropriate pay levels for S corporation shareholders.
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