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It's Important To Pay Corporate Shareholders Properly To Survive A Corporate Audit

Common Small Business Tax Deductions - Is It Tax Deductible?

It's Important To Pay Corporate Shareholders Properly To Survive A Corporate Audit
©2019, Melissa C. Marsh.
Written: 7/8/2008  
By: Melissa C. Marsh

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 itís 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. 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.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this web site is not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed on a taxpayer under the U.S. Internal Revenue Service.

© Copyright 1999-2019 Melissa C. Marsh. All Rights Reserved. All Information on this website is subject to a Disclaimer and Use Agreement. This information is provided as general information only and should not be construed as legal advice. We advise you to seek the advice of competent legal counsel to address your own specific questions, facts and circumstances.

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© Copyright 1999-2019 Melissa C. Marsh. All Rights Reserved