The owners of a corporation are referred to as shareholders. When the corporation is properly organized, maintained, and operated, the shareholders are not liable for corporate actions, even if they own 100% of the stock. In addition, where the corporation is properly operated, the shareholders can take advantage of tax savings not available to unincorporated businesses. When a corporation, however, fails to pay its shareholder-employees who are performing services on behalf of the corporation an appropriate salary, however, the IRS may conduct an audit and severely penalize the corporation and its shareholders.
S-corporations and C-corporations Must Pay Their Employees a Salary.
The shareholders (owners) of a corporation will often work for the corporation, and when they provide services to the corporation, the corporation is required to pay such owner-employees a reasonable salary. During a corporate audit, the IRS will closely scrutinize the compensation paid (or not paid) by a corporation to its shareholders. Paying zero wages to an owner-employee is unreasonable. A corporation is supposed to be a separate legal entity apart from its owner(s). As a separate legal entity, the corporation is supposed to pay wages and issue a W-2 to the shareholder employees who perform services for the corporation. How the IRS will scrutinize a corporation depends on whether it’s a C-corporation or an S-Corporation.
With a C-Corporation, the IRS is concerned about unreasonably high compensation packages because wages are a deductible expense and dividends are not.
With a S-Corporation, the IRS is equally concerned about unreasonably low compensation packages because wages are subject to payroll taxes, and dividend distributions are not.
In both instances, the IRS and a court of law, will determine whether the wages paid were reasonable based on the amount an unrelated person would be paid in wages for the same work at a different company. Subjective factors include the level of experience, the time spent performing the services, and wages paid to other non-shareholder employees. www.salary.com provides a good tool to determine whether the salaries being paid are reasonable.
The Penalty for Failing to Pay a Reasonable Salary is Severe.
The IRS has been auditing S Corporations who appear to be paying their owner-employees, either no wages or less than what it believes is a reasonable wage. The IRS is looking to recover unpaid payroll taxes. The penalty on underpaid payroll taxes is a stiff 100% penalty. Before a corporation distributes any profits, repays any loans from its shareholders, or advances a loan to a shareholder, the Corporation must be certain that it is actually paying reasonable salaries to the shareholder-employees who are providing services to the corporation.
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