Must S-Corporations really pay salaries to the owners?
"Hi William, My wife has just started a business and has decied to go S -Corp. I've read a lot of what you have written about how S Corps work. You have written: 'As an owner-employee of the S-Corp, you will have to pay yourself a salary, and pay payroll taxes on your salary, even if the S-Corp loses money.' Is this still the case if we don't take any distributions from the corporation this year in addition to the fact that we will probably have a loss?
IRS Headliner Volume 32 from Dec 2002 states: 'An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before a non-wage distributions may be made to that shareholder-employee.' I read this as saying if there are no non-wage distributions there does not have to be any salary/payroll.
Am I wrong, and if so, what am I missing? Thanks!"
Aspire,
S-Corporations must pay their employees a salary. Often, the business owners will work for the S-corporation, and the S-corp must pay owner-employees a reasonable salary. Paying zero wages to an owner-employee is unreasonable. (Would you take a job that pays nothing?) Paying wages less than the minimum wage are also unreasonable. (Would you take such a job?) The bottom line: if you decide to go with an S-corporation, the business absolutely must pay wages to owner-employees.
What's the big deal, you ask? First, the IRS has been auditing S-Corporations that pay owner-employees less than reasonable salaries. The Service is looking to recover underpaid payroll taxes. The penalty on unfunded payroll taxes is a stiff 100% penalty. So, in a way, paying wages and payroll taxes now will actually save both money and headaches.
Why is the IRS targeting S-Corporations? The motivation is simple. S-Corporations, unlike the regular C-Corporation, passes-through all profits and losses to the shareholders. In a regular Corporation, profits are distributed in the form of a dividend, which is taxed once at the corporate level as profits and is taxed again on shareholders' tax returns as dividend income. S-Corporations don't pay taxes, instead all the profits are considered distributed to the shareholders, and the income is taxed once on the shareholder's Form 1040.
A shareholder who is also an employee of an S-Corporation is tempted to pay herself less wages and pay herself more profits. The math speaks for itself: wages are subject to FICA payroll taxes (the employer pays 7.65% and the employee pays another 7.65% for Medicare and Social Security taxes). Profits are not subject to FICA taxes, so paying more profits and less wages saves everyone 15.3% in taxes.
The IRS obviously knows this, and is hoping to recover some unpaid payroll taxes.
The real difficulty comes when a company is just starting out, such as your wife's business. Generally, businesses go through two or three lean years, sometimes losing money and sometimes breaking even. After a few years the business will either close or begin making profits. This is a cycle I have seen over and over again with my clients. In the startup years, the owners often tap their own savings and investments to keep the business afloat. And so it strikes many people as silly that they take their own money out of their savings account, put it into their own business, and then pay themselves a salary, plus all those taxes, with their own money.
For this reason alone, I often discourage entrepreneurs from using S-Corporations until the business clearly has enough cash-flow to pay reasonable salaries to the owners. For your wife, she should hire a tax professional with solid experience in small business taxes and find out what her alternatives are. An honest examination of the cash-flow projections for the business might point to a business tax structure that will be the most advantageous to her.
As for the IRS headliner article, here's what the IRS was really saying. Before an S-Corporation can pay out profits, repay loans from shareholders, or advance a loan to a shareholder, the S-Corporation must first pay reasonable salaries to the shareholder-employees. In other words, S-Corporations must pay wages to owners who work for the business. Period.
More information:
- What is an S-Corporation?
- Reasonable Compensation for Shareholder-Employees
- S-Corporation Basics
- Payroll Tax Basics
Do you have a tax question? Visit the Ask a Tax Question page. Disagree with my answers? Post your comments in the Tax Forum.
Regarding “Must S-Corporations really pay salaries to the owners?”, does the same apply to LLC’s? Don
I disagree after reading your IRS excerpt. This is the key right here “An S Corporation must pay reasonable compensation.., before a non-wage distributions may be made to that shareholder-employee”. An S-corp can choose not to pay an owner/employee but the owner/employee can not take a profit without first being paid a reasonable salary. So an S-corp is still a perfectly reasonable vehicle for a new company without any profits.
I agree with Ivan.
The excerpt is simply saying: If compensation is going out the door, then SE tax better be going with it.
And yes, there are plenty of people of means that take $0 salaries from startup companies while it is cash-flow negative. In fact, I don’t know why anyone would think there’s a requirement to pay SE tax on a cash-flow negative biz. Would you care to elaborate on your point of view? (Code cit. would be a good idea.)
Would you work for free? Some people do, but in general, people want to be compensated for their work as an employee. Shareholders of an S-Corp who work for the company are employees. That means they must be paid. There are minimum wage laws, so shareholder-employees must earn at least minimum wage. And the point of the article is that the IRS is auditing S-Corps that report zero compensation for shareholder-employees.
How is the IRS going to say that an S corp losing money needs to take officer salaries/reasonable compensation? The concept is S/E tax-related, of course. So, if a partnership is losing money and the active partners have no income (only losses) to report, should there be some ridiculous calculation to make sure the partners pay some kind of S/E tax? Sorry to call you out, but you’re wrong. If an S corp is losing $$$, there is no requirement to pay “reasonable compensation” when an entity is not making money. By it’s very definition, compensation would not be considered “reasonable” if the entity is losing money? By it’s very nature, compensation is “income”. No income, means no compensation and no S/E tax exposure.
Peter, I would love to agree with you, but the IRS has come down real hard on this very issue. See, for example, their fact sheet on Wage compensation for S-corp officers. The IRS is taking the position that shareholders who also provide services to the S-corp are employees, and thus must be paid. It doesn’t matter to the IRS if the business is losing money or not, it wants us to pay salaries to officers.
William, in the link you gave the IRS states right on the fact sheet “The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly” Meaning you don’t have to pay SS taxes if your business didn’t make any money. Granted if you gross $500,000 and manage to write it all off the IRS will probably come back and say you had indirect wages and need to pay SS tax, but for a startup that truly lost money they wont have to pay FICA/FUTA taxes.
It seems to me from my research thus far and the United States supreme court rulings that legally if you own all shares of the Corperation and have absolute control of the entity. You could fairly argue, rightly, that you are the owner of said corporation and as the proprietor you are not in point of fact an employee subject to salary requirements. This of course would only apply to total ownership of the shares. Any situation where someone else within that entity could effect the action of the company would disqualify the argument of ownership. Legally it is refered to as “the right to control”. The IRS may not recognize it universally but I suspect they haven’t had additional arbitration related to the issue.
The easy way to circumvent the entire issue is to form an LLC, not an S-Corp. There is no requirement for the “members” of LLCs to take “guaranteed payments.” In a subsquent year, when the LLC is making money, you can file forms with the IRS to elect to have your LLC treated as an S-corp for purposes of taxation. I did this myself. Most states will follow how the IRS treats you when you notify them. I have done this for my company, operating in Utah, California, and New Mexico.
If you really insist on forming as S-corp, write to the IRS and request a written response.