|This article does NOT
information on general Partnerships, Sole
Proprietors, and LLCs. These
entities do not pay wages to the owner. Amounts paid to the owner
from partnerships, sole proprietors & LLCs are distributions and
are not subject to payroll taxes but in most cases are subject to
self employment tax and income tax. Federal taxes for these entity
owners are paid quarterly using estimated tax coupons that include payment of federal income tax and social
security taxes (unless the participant is not an active
participant in the business or the business is a passive activity).
This article discusses the S Corporation
Click on the link for a brief overview of the differences between
the C Corporation, S
Corporation or LLC
Officers are employees, therefore they must be
compensated as employees receiving paychecks-
read more - IRS article
November 2005 The IRS announced that the
number of tax-return audits in 2005 increased
by over 20 percent, to 1.22 million, the highest number
in seven years. IRS Commissioner Mark W. Everson said
"Part of the increases comes from improved procedures and part
from a new emphasis on enforcement," he said. The IRS budget increased 4.3 percent for 2006 with a nearly 8
percent increase for enforcement. The Wasington post
published this about the 2007 budget "The
IRS, after years of shifting resources to improve taxpayer service,
has come under fire for what critics see as inadequate attention to
enforcement. So the agency has been swinging back in recent years,
and that trend would continue next year as budget authority for
taxpayer assistance, return processing and other management
functions would decline 1.2 percent, while enforcement would rise
by 1.8 percent"
The years (15 or more) where we have seen a "kindler &
gentler" IRS with very few audits is coming to an end. Congress is sending a message
to the IRS. Collect More! So be wary S Corporation owners.
The issue of reasonable compensation is an easy IRS target and
a large revenue generator for the IRS. Consider contacting a
local employment agency, provide them with a list of your management
responsibilities and hours worked and have them put into writing
what it would cost to hire a person to fill your shoes and keep this
paper in the same file where you keep a copy of your tax returns.
S Corp owners may withdraw
earnings from the business as:
- distributions from S corporation earnings (similar to dividends of a C
- repayment of loans
- reimbursed expenses
from an S Corp are not subject to FICA and Medicare taxes.
This translates to a
potential savings of up to 15.3%. Withdrawals in
the form of distributions (dividends) are still subject to
federal taxes at the ordinary
income tax rates-
top tax bracket 35% (Recently tax changes provide for a tax break on C corporations dividends
-top rate of 15% - but this does not apply to S
to FICA and Medicare payroll taxes (15.3%) and are subject to
ordinary income tax rates. But the bonus to paying wages
opens up the opportunity to fund a pension that will save federal taxes at the
ordinary income rates (top tax rate 35%). Pension rules
generally permit funding a pension as a percentage of your
are not wages and therefore are not counted in the pension
contribution calculation). The tax
savings will continue when money is contributed to a pension because
the pension will grow tax
free until retirement (compounding the growth of the investment).
Loans should be repaid with
reasonable interest which is
subject to income tax but (interest) is deductible as a business expense.
So, as an average taxpayer you will have not have an increase in taxes
as a result of the interest paid, but this is a bit of bureaucracy
which we recommend you follow. Paying interest will provide support
that the loan is arms length and not a disguised capital
contribution. Good business practice dictates that when you lend money to your corporation
you must get
a formal Note (in writing). If you want the loan repaid without
tax consequence, you will follow these guidelines. Most
business owners will
fund the start-up checking account with money from their personal
accounts. A portion of these
funds should be allocated on the balance sheet as a capital contribution (payment for the
purchase of company stock). The amount allocated to Capital should
be a reasonable value ( for example $1000 for
a service business, more for a business that requires significant
purchases of inventory or machinery). The remainder invested may be repaid as
a loan provided there is a note drawn and interest payments are made at regular intervals at a
reasonable rate of interest according to the note document.
Lack of interest payments would infer the debt is contingent upon
corporate profits, which is considered a second class of stock. A
second class of stock will permit the IRS to discard the S election
and submit your company to C corporation taxes (double taxation.)
paid from an owners pocket
can be repaid to the S Corp owner with a company check. Just a side
note - try to
pay the vendor/ payee directly with company funds. There could be
more scrutiny with reimbursed expenses than payments directly from
the business account .
For charge cards used for both personal and business purposes, send 2
checks, one from your personal account to pay personal charges and
one from the business account to pay business expenses
Strategy 1: Lets take the example of a
new attorney who for the first year of business will earn after
(but before wages) $90,000 (the 2005 FICA limit).
For every dollar his wage falls below the social security limit he
and his company saves a combined 15.3 cents in payroll taxes.
Lets assume that from these S Corporation earnings of $90,000 a wage of $50,000 per year
is paid and the remainder of $40,000 is paid as a
"distribution". The payroll tax savings (
$40,000 -not subject to social security- x 15.3% ) would
save $6,120 per year.
The attorney starts a
profit sharing pension plan in year one and contributes the maximum
(25% of wages with an upper limit of $42,000
With a $50,000 wage his pension
limited to $12,500 ($50,000 x 25%). This pension expense will save as much as $2500
(depending upon his personal tax bracket) in federal income
With an allocation of $50,000
wage and $40,000
distributions and $12,500 pension contribution he has
saved $8,620 in federal income taxes.
Strategy 2: All earnings paid as
$90,000 paid as
wages. While there is no social security tax savings, the
attorney can contribute $22,500 (25% x 87,000) as a pension
contribution saving as much as (depending on his
tax bracket) $4,700 on federal income taxes .
Result of selecting Strategy 1 over
Strategy 2: An increased tax savings of $3,400.
Benefits of strategy 2:
- The additional pension contribution
($10,000) will grow "tax
free" until retirement, preserving wealth and compounding
- Contributions are made toward social security benefits.
"distributions" - s corp
dividends - are not taxed
therefore not counted towards your retirement benefit. To find out
how withdrawing earnings on distributions rather than as of
request a free social security statement. Request several statements.
Complete each request with a different projected wage. For
a quick calculation can use
online calculators and input various scenarios to see how your
benefits can be affected by your decisions.
Other - in most cases if you contribute 25% to your pension, you
will be required to contribute 25% to your employee's pension.
It is important
to consult with your CPA to determine the right balance between
and "distributions" and to revisit this decision annually.
Stick to the program!
Once you have established the most tax effective strategy,
follow it. Click on this link:
The IRS loves to collect payroll taxes and will
seek out an S Corporation that pays NO wages
to officers of the corporation or pays unreasonably small
wages. Why? To collect
additional payroll taxes.
Here is an option that will provide for
flexible cash payments but still adhere to a structured wage
Pay yourself a wage once a month (or
more as long as the intervals are regular and the amount is
consistent) on the first of every month
and on the 15th pay yourself a "distribution"
from S Corp earnings (cash permitting).
Monthly "distributions" can
vary in amounts or not be paid at all.
should be paid at regular intervals in regular amounts.
Try not to give the IRS ammunition for reclassifying
to wages. The result is a
catastrophe. Payroll taxes plus late payment and filing penalties.
Avoid problems by complying with these suggestions:
- Distributions should recorded in the corporate minutes each time a
dividend payment is made.
- The distribution payment should be stated as
a dollar value
per share (to the nearest whole dollar) times the number of
- Do not make "distributions"
more frequently than once a month. If cash flow does not
permit a dividend one month, wait until the 15th (or declaration
date) of the following month for a distribution payment.
- Distributions must be paid to all
shareholders on the same date
in proportion to the ownership
percentage. Non pro rata distributions could result in the loss of
S status because of the one class of stock requirement.
- Do not pay your personal bills through the
business and call them distributions.
- Pay reasonable wages
(see below for a discussion of reasonable)
- If your company is losing money and you do
not have retained earnings from prior years, do not pay
distributions. In other words, do not borrow money (higher vendor
payables, or company borrows from bank, or company increases
credit card debt) and then pay yourself a distribution. This
creates "basis" problems and red flags your tax return for
scrutiny by the IRS
The last consideration, and most important, is
whether your split between wage and
distributions seems reasonable to
the IRS. Below are a few guidelines of how the IRS determines
Compensation is deductible only to the extent it is reasonable.
Compensation paid to employee-shareholders must be paid purely for
services, or have a purely compensatory purpose, in order to be deductible
Closely held corporations that have the controlling shareholders and their
families setting their own compensation figures will be more closely scrutinized
under an audit.
Other factors determining reasonableness include:
These are important and your position should be defined before determining
your gross wage.
- the employee's qualifications and role in the company, including factors
such as hours worked the employee's position, duties performed, and his
overall contributions to the company
- the character and condition of the company, including factors such as the
size of the company, the complexity of its business and the general economic
- a comparison of the employee's compensation
with the compensation paid by similar companies for comparable
- ability and achievements of the employee (would an outside investor have
paid the compensation amount based on performance);
- volume of business handled by the employee;
- complexities of the business;
- relationship of compensation to gross and net income of the business;
- living conditions in locality;
- the salary policy of the company for all its employees and
the particular employee's salary history with the company
These factors are not listed in any order of importance. No
one factor will determine a particular case. However, in a particular
situation, a single factor could be persuasive.
Paying distributions as opposed to wages vs distributions will save tax
dollars. Even if you pay a wage of over the Social security limit of $90,000
(for 2005) there is still a 2.9% savings
(the Medicare rate) on the portion of earnings taken as distributions (not
wages). For new businesses, you may set a lower reasonable wage if most
hours are spent on tasks that are administrative (a lower paying rate) or
established business owners might have employees that are capable of managing
the business and requiring less time on the job for the owner translating into a lower
reasonable compensation rate.
It is very important to work with your CPA when setting reasonable compensation. Keep a record in the
corporate minutes on what facts and circumstances were used when
calculating a value for reasonable. The issue of reasonable compensation is a
difficult one, discuss this issue at the start of each year.
take a moment to read this section on how to
record payments to shareholders in QuickBooks
Which account should you choose?
Set up the following accounts to help track the
payments: From the List menu, select accounts and add new
account (control + N)
Long term liability
Officer Loan- Joe
Capital Contributions -Joe
Capital Contributions -Rich
Distributions - Rich
assume 2 Shareholders - Joe and Rich
Scenario A : Joe tells you to cut the check
that is not business related, and does
not identify what it is for
I suggest coding the entire amount to Officer Loan payments.
Distributions must be paid in equal amounts based on ownership
percentage to all shareholders on the same date. So if Joe takes a
check, so must Rich. And if this does not occur, don't call it a
It does not matter that the officer loan account is a liability
account code the loan
receivable payment to officer loan -Joe. At the end of the year, the accountant will create any journal entries
needed to reclassify appropriate amounts to salary and
capital. Ask Joe to make a deposit of $500 to $1000 of his own
funds into the business checking to be categorized to Officer Loan
payments. This 'cushion' will give you CPA the support needed to call the deposit
interest from officer
(if necessary) at the end of the year.
Print out a
quarterly report of account Officer loan -Joe and faxing to the CPA with a message as
follows: "Please let me know if you believe any of these
amounts should be categorized as salary and help me make the
proper adjustment in QuickBooks. Also provide assistance
in making sure any amounts reclassified as wages have been grossed
up in my payroll summary report with adequate tax withholdings so
that I can pay the payroll taxes timely".
Scenario B: To start up the
new business, Rich deposits 10,000 of his own funds into the
account and Joe deposits nothing. I suggest:
Classify part of the $10,000 to Joe's
capital account based
on a per share price
Classify part of the $10,000 to Rich's capital account
based on the same per share price
Classify the remainder of the $10,000 to Rich's officer loan account
Capital stock must be purchased for a reasonable amount. S
Corporations only have one class of stock so the price must be the
same per share for each owner. Therefore, for Joe to be an owner,
he must pay the same price per share as Rich. Discuss the
possibility of Rich lending money to Joe for
the purchase (a transaction which is a personal transaction - has
nothing to do with the business). Decide on a price per
share, code part of the 10,000 to each capital account and classify the excess as a
loan payable to officer loan - Rich.
If Rich is not in agreement with this, then Joe needs to have
amounts withheld from his paycheck to pay for the stock.
Continuation of Scenario B : Rich now has loan principle due
to him from the corporation
For a loan to be considered valid by the IRS,
interest must be
paid to Rich in
regular installments. Quarterly would be a good choice. The
interest rate should approximate fair market value interest
rates. Write a check quarterly to Rich and code to Interest
At the end of the year, a 1099-INT must be completed and mailed to
Rich before 2/28/xx. One copy is mailed to the IRS with form 1098
and one copy send into the State.
Scenario C: Paychecks are cut to Joe and Rich for wages
without having any taxes withheld.
Gross up the net checks to gross officer salaries and remit payroll
taxes as due
Scenario D: Its time to
pay the American Express bill and Joe never provides you with the
Sit down with the Joe for a heart to heart. Suggest
that he give you the credit card statement so you can pull out
every single transaction that could possibly be construed as
business expense and categorize accordingly. The
remainder classify to "officer loan-Joe" and let the
accountant determine the best course of action. Saving
the categorizing to the end of the year means lost statements
tax preparation fees. Don't forget to give the accountant
a listing of the transactions in the officer loan account before
the year end. And ask Joe to deposit $500 or $1000 into the
business account so the accountant has some flexibility in
coding some amount as interest paid from Joe to the company on
any officer loan that exists. The goal is to make sure
that the IRS will not come back and construe the payment as a
distribution from earnings to Joe. A distribution that would
create an inequity between Joe & Rich's ownership %.
Remember, making inequitable payments creates the basis
for the IRS to assign a second class of
stock and jeopardizes the S Corp Election. Lose an S
Election and be prepared to pay hefty penalties and late income
taxes on the corporation.
Read about automatic download of American Express
transactions into QuickBooks. It might be a good idea to acquire
a separate AmEX account that the owners use strictly or business
purposes where the bookkeeper can download new transactions
daily and categorize accordingly. And questions can be answered
while the purchase is still fresh in the owner's mind.
Scenario E: Rich
gets sick while on vacation and receives
medical care from a
physician who is out of network. He asks you to pay the
Code the payment to "officer loan-Rich" and remind Rich that
health costs are a personal expense and are not deductible for
the S Corporation. In fact if the benefit is not offered to all employees,
it must be grossed up in wages and included on the W-2.
Pay the bill and ask Rich to reimburse the company or include
the payment in wages.
Read more about reporting S
Corporation owners health benefits in the W-2 at year end.
Its April 15th and both Rich and Joe have huge
tax bills on
their personal 1040's. They ask you to cut a check in the amount
of each tax liability payable to the IRS. The amount to be
paid on behalf of each owner is not in proportion to their
If possible, cut a check to each owner in an amount that is
proportionate to ownership and code both checks to capital
distributions- Joe and distributions Rich . Let them
deposit into their personal accounts and write their own checks.
Don't give the IRS any support for a "second class of stock
If not possible, cut the tax checks, plus an additional
check in the amount of the difference between the first two tax
and pay it to the shareholder who had the lesser tax bill.
(This assumes equal ownership, if this not the case, calculate the
amount needed to have distributions in line with ownership and
payout the shortage) Code all three checks to the
owner's distribution accounts..
company is making lots of money, but the extra cash is kept
within the company to fund growing inventory and accounts
receivable. Distributions are less than earnings.
Do nothing. Its okay to payout less than the earnings.
The owners will still be taxed on the income but when payment is
finally made, it is does not get taxed again. (Some
states have a tax on assets retained in the company as of 12/31,
for these companies, check with your accountant and if cash is
subject to this tax, payout available cash by 12/31. Have
the owners deposit the payout into their personal accounts and
if the company is now short on funds, the owners can write a check to the company from their personal accounts
in early January to loan the company the money needed. Don't forget to pay the owners interest on the
loans quarterly until the loan is repaid.
Do not track what money has been taxed and
what has not. That is the purpose of the accumulated
adjustments account on the tax return (earnings previously
reported on the owners 1040 tax return). You accountant based on
your regular bookkeeping entries will be able to determine what
the balance remaining is in the accumulated adjustments account.
The company is loosing money and cannot afford to pay
payroll taxes on the money withdrawn by the owners.
Get the accountant involved. If the company is loosing
money and there are no retained earnings from prior years,
withdrawals by the owners are deemed salaries and are subject to
payroll taxes. Loans receivable from owners of over
$10,000 are subject to scrutiny by the IRS. Don't red flag
the tax return with these officer loans receivable. Have
the accountant discuss other sources of cash to help defer household expenses until the
cash flow loosens up.