S corporation owners enjoy limited personal liability and a beneficial pass-through tax structure. However, they also face unique tax restrictions that don’t apply to other business entities. Here are some S corporation tax no-nos to avoid to stay on good terms with the IRS.
Salaries vs. Distributions
One of the primary reasons business owners choose an S corporation is the tax structure. Shareholder income from an S corporation is not treated as self-employment income. That means S corporation owners don’t have to pay the current self-employment tax rate of 15.3 percent on their share of the net income. In contrast, sole proprietors and single-member LLCs pay self-employment tax along with regular income taxes on business net income. With Social Security taxes at 12.4 percent and Medicare taxes at 2.9 percent, a business owner could conceivably save tens of thousands of dollars by taking a distribution of income in lieu of a salary.
Choose a Reasonable Salary
To keep S corporation owners from abusing this tax advantage, however, the IRS requires that you pay yourself a reasonable salary. S corporation owners should consider the makeup of business revenue when setting a salary. For example, say that you’re the sole owner of an S corporation and all business revenue comes from your professional services. Logically, your services represent most of the business net income, and your salary should, too. However, you could also gain revenue from capital, equipment, or the work of other employees. If this is the case, there’s an argument that the revenue isn’t from your personal services, so you can take more profit as a distribution.
When evaluating the whether your salary is reasonable, the IRS also considers your experience, training, responsibilities, and time commitment to the company. However, a reasonable salary is a subjective number, so you should have some justification for the salary you chose. Look at salary data for your profession and consult with your CPA to set an appropriate figure.
Watch Out For Fringe Benefits
Normally, the cost of health insurance premiums for employees is a deductible expense for a business. But there’s a special exception for S corporations, which are not allowed to deduct health insurance premiums paid for shareholder-employees who own more than 2 percent of the company. The S corporation has to include those payments with its shareholder-employee wages when it issues annual W-2s.
As a consolation, owners can write off the payments as a self-employed health insurance deduction on their personal tax returns. Keep track of the payments made for your premiums throughout the year and report them on line 29 of your Form 1040 (PDF).
Restrict Stock Ownership
Whereas C corporations have virtually no restrictions on who can own stock, S corporations have quite a few. You can only have a maximum of 100 shareholders in your S corporation, and only one class of stock — although you can issue stock that doesn’t have voting rights. Also, you can’t allow a partnership, corporation, or foreign person to be a shareholder. Violating any of these guidelines could cause the IRS to terminate your S corporation status.