S Corporations and Reasonable Compensation

If you’re a small business owner, you may have heard the term “S corporation” or “S corp”. If you haven’t, then I’m guessing that you haven’t had a conversation with a CPA lately. Small businesses choose to make an “S” election to eliminate the self-employment tax on net income that a sole proprietor, single or multi-member LLC, or partnership would ordinarily be subject to. While there is this valuable tax benefit (13.3% for 2012) to being an S corporation for tax purposes, it’s extremely important to be aware that the savings on self-employment tax is not a giveaway by IRS, and if you’re not careful, it can cost you.

While it’s very tempting to just claim the net income from your S corp on your personal tax return, and only pay income tax (and no self-employment tax) on that income, IRS wants to see you pay yourself a “reasonable compensation” if you perform services for your S corp. If you’re the 100% shareholder and only person involved in your S corp, it would be difficult to claim that you provided no services for your own business, so you need to take a salary, the same way that you would pay a salary to an employee, since you’re in reality an employee of your own S corp. As such, you also become involved with filing quarterly payroll tax returns, making federal and state unemployment contributions, and issuing yourself a W-2 at the end of the year.

If you’re a small business that has made the S election, and are thinking “the heck with taking a reasonable compensation”, be advised that this is something that has seen a lot of noncompliance and abuse in recent past, and it’s on IRS’s radar. They’ve won many court cases on this subject, in spite of the fact that the Internal Revenue Code doesn’t explicitly define what “reasonable compensation” means, even though they’ve issued a fact sheet about compensation for S Corporation officers (just Google “FS-2008-25”).

Making an S election can be a source of significant tax savings, even with the additional costs of using a payroll service to issue paychecks to you and file payroll tax returns, and having a CPA prepare a separate tax return for the business (Form 1120S). It may be worth your while to invest a few dollars in having your tax professional run a side by side comparison of how much total tax you’d pay without having the S election vs. how much you’d pay with the election.

Please share this article with fellow business owners, and leave a comment on your own experience with being an S corp.

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