Today's tax question comes from "Aspire," who is starting his own business. He asks:
"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!"
An owner of an S-corporation might wear two hats. One is as the owner of the business, entitled to receive a share of the net profits of the business. Oftentimes, the owner will also work for the business, and thus be an employee of the firm. Thus an owner-employee of an S-corporation can receive two different types of income: net profits (or losses) and salary income.
Your reading of the IRS headliner is quite ingenious. It's clear that the IRS is analyzing the situation in which the S-corporation is prepared to distribute funds to an owner-employee, and the IRS is saying before profits can be distributed, the S-corporation must first determine to what extend any of those funds represent compensation for services rendered as an employee. Your question is whether salary must still be paid even if there are no distributions to be made to the owners.
I think that's a complex question. The clearest guidance I can find is in the fact sheet, "Wage Compensation for S Corporation Officers" (FS-2008-25). There the IRS lays out the following two-step thought process:
- "Generally, an officer of a corporation is an employee of the corporation." This implies an employee-employer relationship between a corporate officer (such as President, CEO, etc.) and the corporation. In a small S-corporation, the officer could also be the shareholder. So this same person would have two distinct roles: that of a shareholder and that of an employee.
- "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation" Here the IRS is saying the same thing as it said above in the headliner: that the S-corporation must determine the extent to which payments to a shareholder-employee are treated as salary and the remainder can be treated as distributions of net profit.
Later on in the same fact sheet, the IRS makes the intriguing comment, "The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly." This statement may correspond to your own interpretation.
However, I have some deep reservations about these statements from the IRS. If shareholders working for their own S-corporation really are employees, then it logically follows that employees must be paid some sort of wage. Of course, tax rules are not always logical, but I think this would be a reasonable extension of the IRS's own line of thinking.
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 the various payroll taxes, with their own money.
For your wife, she should consult with 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 solution that will be defensible before the IRS and help put the business on solid financial footing.
- What is an S-Corporation?
- Reasonable Compensation for Shareholder-Employees
- S-Corporation Basics
- Payroll Tax Basics