Shareholder-employees will therefore receive two tax documents from the S-Corporation: a W-2 wage statement and a Schedule K-1 statement.
Shareholder-employees are taxed on their wage income and on any profits distributed by the S-Corporation. These profits are taxed as ordinary income instead of the more favorable qualified dividends tax rate. Dividends are a distribution of corporate profits to shareholders, but a qualified dividend has already been taxed at the corporate level, so a qualified dividend is taxed at a preferential tax rate on the individual tax return. S-Corporation profits, however, have not already been taxed, and so they will be taxed as ordinary income on the shareholder's tax return.
Because shareholder-employees receive both wages and profits from the S-Corporation, there is a strong temptation to pay a lower salary and a higher profit distribution. Wages are subject to FICA payroll taxes. The S-Corporation will pay the employer's share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S-Corporation and the shareholder, wages are subject to a combined 15.3% payroll tax, plus the shareholder's income tax rate. Profit distributions, however, are not subject to FICA payroll taxes; they are subject only to the shareholder's income tax rate. So all things considered, the shareholder-employee will have a strong preference to pay herself a minimal salary and thereby increase the profit distribution.
The IRS is fully aware of this situation, and they are actively seeking out S-Corporations paying out below-average wages. The IRS has said over and over again that S-Corporations must pay their shareholder-employees a "reasonable compensation" for services rendered to the company. See more about reasonable compensation in my tax tips and audit strategies for S-Corporations.
