Payroll Vs. Distributions
Owners of S corporations can choose to take their compensation either as payroll wages or as shareholder distributions. While standard payroll wages are subject to federal payroll taxes, including income taxes and Social Security contributions, shareholder distributions are exempt from these taxes and are taxed at a lower rate. The Internal Revenue Service requires that shareholders take a "fair and reasonable amount" of their compensation in payroll wages.
Corporate shareholders are eligible to receive income distributions when the company makes a profit. Unlike traditional C corporations, which disburse distributions through cash or stock dividends, an S corporation is a "pass-through" entity. The income in an S corporation passes directly to the shareholders in proportion to their percentage of ownership in the company. Some S corporation owners may choose to take as much compensation as possible from shareholder distributions to avoid payroll taxes.
A shareholder in an S corporation is also considered an employee of that corporation for the purposes of taxation. As both business owners and employees, S corporation shareholders must also pay federal and state payroll and self-employment taxes. A shareholder must also take an amount at or above an average wage for his duties as compensation. Any attempts to bypass taking a smaller amount to avoid payroll taxes can bring unwanted attention from the IRS.
S corporation shareholders can determine what a fair wage would be for their duties. These criteria give the shareholders a point of comparison between their tasks as owner-operators and those of a non-owner employee in the same position. The criteria can include the time and effort involved in running the operation, the experience level required to accomplish the business tasks, the cost of living in the company's area and the timing and methods of any bonus payments.
In recent years, the IRS has targeted S corporation shareholders who have failed to disburse adequate wages to themselves as employees. The agency estimates that such methods have cost government programs billions of dollars in lost revenues. In 2000, the IRS stated that more than 400,000 S corporation shareholders paid themselves no salary at all. These actions led the agency to audit thousands of companies and forced the owners to pay back taxes, fines and penalties.