As a small business owner, you spend countless hours working on your business. Now that the business is finally generating a profit, the last thing you want to is pay more in taxes than you need to.
If your business is set up as a partnership or an LLC, your income is subject to self employment taxes. However, if your business is established as an S-corporation, you are not subject to self-employment taxes. This is because you are treated as an employee of the S-corporation. As an employee, your wages are subject to the same payroll taxes that any employee’s wages are subject to.
Self-employment taxes are designed to achieve a similar result as payroll taxes. Therefore, theoretically there should not be any significant difference in taxes paid between an LLC and an S-corporation. However, many S-corporation shareholder-employees discovered a loophole. If an S-corporation shareholder-employee takes very little to no compensation and primarily takes shareholder distributions from the business, less taxes would be paid.
Be warned though that S-corporation shareholder-employees are required to take a reasonable salary. There are a number of factors that are used to determine what is a reasonable salary:
- Timing and experience;
- Duties and responsibilities;
- Time and effort devoted to the business;
- Dividend history;
- Payments to non-shareholder employees;
- Timing and manner of paying bonuses to key people;
- What comparable businesses pay for similar services;
- Compensation agreements; and
- The use of a formula to determine compensation.
If the IRS determines that your compensation is inadequate or unreasonable, it has the authority to reclassify amounts you received as a distribution as compensation.
There have been a number of tax court cases in recent years in which the IRS has successfully reclassified distributions as compensation. In one case, the shareholder was the only employee of the business and he did not take any salary. Instead, all the money he withdrew from the business was classified as distributions. Because all of the income was derived from his own efforts and the distributions paid to him would be a reasonable amount for a full-time worker in his position, the courts upheld the IRS’ reclassification of the distributions as compensation.
In another case, a business owner with over 20 years of experience within his field paid himself a salary of $24,000 and took more than $200,000 in distributions. It was eventually determined that others in a similar position within his industry were paid a salary of $67,000, so a portion of his distributions were reclassified.