Q. Part of my small business tax strategy is to use an S corporation distribution in addition to drawing a salary. What should I consider when determining an appropriate salary amount?

by Graham Hill on May 08, 2012

Earlier this year, while still a GOP presidential candidate, Newt Gingrich released his tax returns and brought a controversial tax strategy into the public spotlight. Use of this particular strategy – and the controversy surrounding it – is not limited to the political elite.

Millions of small business owners avoid paying payroll taxes on their income by taking distributions from their S corporations, which are not subject to payroll taxes, in addition to salaries, which are subject to payroll taxes. When using this tax strategy, it can be difficult to determine an appropriate salary and small business owners and their tax advisors must consider the unique facts and circumstances of the taxpayer’s situation.

However, a spike in IRS audits focusing on this issue indicates a growing interest in curbing abuse of this popular strategy. In these audits, the IRS attempts to reclassify nonwage distributions as salary, thus forcing the S corporation to pay additional employment taxes, interest and penalties.

In at least one recent case, the IRS was successful in arguing that the tax law requires S corporations to pay employment taxes on the amount of distributions that represent “reasonable compensation” for their employees’ services.

The U.S. Court of Appeals provided the criteria as to just what constitutes “reasonable compensation.” The court found that the intent of the corporation in making the payments is irrelevant and instead focused on whether the payments were made in compensation for service.

To determine what is reasonable compensation, the court looked to factors such as:

• experience level of the employee;
• amount of time the employee devoted to the business;
• compensation of others similarly situated

The methodology utilized by the IRS and the courts, as revealed in the ruling, provides a framework for tax advisors and their clients in setting acceptable salaries. Small business owners who have elected S corporation status should be careful that the salaries they pay to their employees are reasonable in light of the recent ruling.

Coauthor: James B. Davis

This post is for general information only. It is not legal advice, and legal counsel should be contacted before any action is taken that might be influenced by this information.