S Corporations – How Should I Pay Myself?

Question: “How do I pay myself from my S corp?”

Answer: Carefully! This is an issue that is often misunderstood by S corp[1] owners!

Many S corps are owned by just one or two people who work for the business full-time (for example, Roger’s Plumbing and Parts, where Roger serves as the office manager, bookkeeper, service provider, president, Board of Directors, etc.). Because of this, many S corp owners operate their entities with a high level of informality, but it can be very risky to operate informally when it comes to the decision of how and when to pay yourself from the business.

Thus, understanding the difference between shareholder distributions and reasonable compensation is crucial for any owner of an S corp.

Reasonable Compensation

 S corps are required to pay “reasonable compensation” to any shareholder-employee for the services that the employee provides to the business. Reasonable compensation means wages – a regular paycheck where proper income tax, Social Security and Medicare deductions are made and a Form W-2 is issued at the end of the year.  

Reasonable compensation should be established according to the value of the work performed by the shareholder-employee.

Shareholder Distributions

Distributions are the profits of an S corp that are paid out or “passed through” to shareholders. Distributions are not wages, so you do not have to make payments for income tax and other wage withholdings on them. This gives S corp owners a lot of motivation to classify their personal earnings as distributions instead of wages. More actual cash in your pocket!

The IRS

However, the IRS has made clear that reasonable compensation to shareholder-employees must be paid before non-wage distributions are made. If the S corp fails to do so, the IRS may reclassify distribution payments to wages, then assess payroll tax penalties and interest for late filing and late payment. In recent years, the IRS has made auditing S corps a top priority in order to review their shareholder-employee compensation methods, so it is not a risk to be ignored!

An even more drastic consequence could be losing your S corp status altogether. If the IRS makes a reclassification and adjustment to just one shareholder’s pay, this may cause all the shareholder distributions for that period to become disproportionate. Since S corporations are generally required to make distributions to shareholders on a pro rata basis, a decrease in only one shareholder’s distributions could create disproportionate distributions, which in a severe case, could terminate the S election and now the business is a C corporation subject to “double taxation”.

Best Practices

First, an owner-employee’s reasonable compensation should match a market rate of pay for individuals in the same industry and with the same title. Recent Tax Court cases have put a heavy emphasis on the use of comparability data to determine market rates of pay. The U.S. Department of Labor’s National Compensation Survey might be a good place to start if you are unsure.

Next, the IRS wants to see the decision to make a shareholder distributions substantiated by formal corporate action of the S corp’s Board of Directors, by way of meeting minutes or a consent in lieu of meeting. If you do not formalize the corporate decision to pay distributions, the IRS could determine they were improper. The IRS also gets suspicious if distributions are always made concurrently with wage payments without corporate minutes. In such a case, it may appear the S corp is improperly dividing up the regular wage payments simply to lower its payroll taxes and the shareholder-employee’s required withholdings.

To summarize, best practices for any S corp owner are to only make distributions after reasonable compensation has been fully evaluated, documented and paid, and after the corporate authorization to make the distribution has been formalized with corporate minutes.

If you need assistance with reasonable compensation, internal corporate governance or IRS issues, contact our attorneys today!

 

[1] Understand that an “S corporation” is not actually a separate kind of legal entity. It is simply a a closely-held entity, either a corporation or an LLC, that had made a valid election with the IRS to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. Some attorneys and accountants do not like to see “S corp” being used the way I have in this post and prefer the accuracy of saying “a corporation/LLC that qualifies for S corporation status”, but I find using “S corp” to be a helpful shorthand.


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