Watch out for this if you are an S-Corporation

It should be no surprise by now that the IRS is continuing to go after S-corporations who pay a low amount of salary to their owners, in order to avoid having to pay payroll taxes on the entire amount of earnings of the company, which can amount to 15.3%. The way this normally works is the owner declares a salary that is substantially lower than the entire amount of the earnings of the business. The business then pays the payroll taxes on that amount, withholding the portion of the employee’s share. The balance of the income of the S-Corporation is taxable to the owner as regular income, not subject to any payroll taxes. This methodology can be used successfully, provided that the amount of the salary is considered reasonable. A salary is considered reasonable if an outside third party would be paid the same amount. If not, the IRS will attempt to recharacterize a portion of the amount as salary.

In a recent case, a CPA formed an S-Corporation to serve as a partner in an accounting firm. The earnings of the S-Corporation “partner” from the accounting firm amounted to over $200,000. The S-Corporation paid the CPA a salary of $24,000. An appeals court agreed with the IRS that the amount of the salary was unreasonably low and after having expert testimony, the court concluded that the salary should have been $91,000. In determining what was considered a reasonable salary, the court determined that the CPA was not a partner who performed significant services. Otherwise, a much larger amount, maybe the entire amount, would have been considered a salary that would be considered reasonable.

It is obvious that the IRS knows how this is played and does not like it. To avoid having a confrontation with the IRS, make sure to establish by outside evidence what would be considered a reasonable salary and keep it in your files in case of audit.