S Corporations and Shareholder Compensation
Shareholders of an S corporation must take a reasonable salary for their work that. The IRS focuses on whether an S corporation pays reasonable compensation to its shareholders. Shareholders avoid paying themselves a salary to reduce employment taxes (Social Security/Medicare.) If a shareholder treats withdrawals out of the corporation as dividends, it can save Federal and State employment taxes. S corporation filing a 1120S showing income but no salaries to shareholders (or salaries less than the Social Security tax limit) is a main item potentially triggering an audit.
Shareholders not paying Salary lose in Audits and Court
The IRS audit will change the net income of the S Corporation from distributions to Shareholder wages. Many accountants try to push the idea of paying lower wages to save employment taxes. Nevertheless, Court case after case has held that a Shareholder of an S corporation who performs substantial services for the Corporation is considered an employee. All monies paid to the shareholder are then subject to federal employment taxes. Shareholders frequently lose in audits and in court in attempting to avoid federal employment taxes by characterizing compensation paid as distributions of the corporation’s net income, rather than wages. The IRS treats the S shareholders as employees and the entire distributions as wages and there are substantial penalties and interest charges.
Exception for Capital Equipment
The exception is if there is a significant return to capital. For example, if an S corporation has a large amount of machinery and equipment, it can be argued that some profit is due to the capital investment not just the service of the Shareholders.