Wages or dividends? An important tax issue for shareholder-employees
S corporations are the most popular form of corporate business structure. There are excellent tax planning benefits uniquely available to S corporation shareholders who are also employees, not the least of which is the opportunity to manage self-employment and payroll tax liabilities. Unlike sole proprietorships, for example, S corporations can pay wages to shareholder-employees and also distribute income to them as corporate dividends, which are free of the payroll taxes that apply to wages.
 Do a comparison
If your business is a sole proprietorship with net income of $200,000, 92.35% of this amount (or $184,700) will be subject to self-employment tax. The social security portion of the tax is 12.4% on the first $106,800. The Medicare tax of 2.9% applies to the full $184,700. So your self-employment tax will be $18,600. You can take a deduction for 50% of this tax.
If you incorporate and elect to be taxed as an S corporation, the result can be dramatically different. Again assume that your business income is $200,000, and the corporation pays you a salary of $60,000 (which you can demonstrate as reasonable). You and the corporation, as your employer, will pay a combined 15.3% on your $60,000 salary as payroll (FICA) taxes. The total tax is $9,180. The remaining $140,000 of business income can be distributed to you as S corporation dividends free of payroll or self-employment taxes. The result is a significant tax savings.
The IRS is very much aware of the potential for abuse by taxpayers paying unreasonably high or low salaries. In the example above, if the IRS determined that your salary was set low to avoid taxes, you could face a reclassification of all or part of your $140,000 S corporation dividends as wages subject to payroll taxes. The key: Pay reasonable and well-documented salaries.
So what is "reasonable"?
Determining whether wages are reasonable involves many factors, including the nature of the services performed, the responsibilities involved, the time spent, the size and complexity of the business, prevailing economic conditions, compensation paid by comparable firms for comparable services, and salaries paid in prior years. There are no hard and fast rules, and there is no definition of "reasonable" in the tax law. To analyze this strategy for your particular business situation, give us a call.
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