S-Corporations, common issues:

Employee-Shareholders of S-corporations must be paid a reasonable salary:

 
When an S-corporation employee-shareholder receives a draw or cash distribution or “dividend” with little or no corresponding wages the IRS may deem this as employment tax evasion and subsequently convert part or all of the draw to wages which are fully subject to payroll withholding and employment taxes.  Quite often small business owners elect S-corporation status, take a draw, and neglect to file payroll tax returns and remit payroll taxes.  This all-too-common scenario results in a taxing surprise to the small business owner.  S-corporation employee-shareholders must pay themselves a reasonable salary in order to avoid this surprise.

The IRS or the Internal Revenue Code does not explicitly define the term “reasonable salary.”  The following factors, among others, can guide the S-corporation employee-shareholders’ determination of a “reasonable salary”:

• Duties and responsibilities
• Training and experience
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees

Although not fool-proof the above factors may mitigate an IRS conversion of draws to salary.

Treating Medical Insurance Premiums as Wages:

Another often missed item by S-Corporations is that health and accident insurance premiums paid on behalf of the greater than two percent shareholder-employee are deductible and reportable by the S Corporation as wages for income tax withholding on the shareholder-employee’s Form W-2.

These benefits are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. The additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder-employee, but would not be included in Boxes 3 and 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an Adjusted Gross Income (AGI) deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S-corporation and the shareholder meets the other self-employed medical insurance deduction requirements.  If, however, the shareholder or the  shareholder’s spouse is eligible to participate in any subsidized health care plan then the shareholder is not entitled to the AGI deduction.

Navigating these rules can be tricky.  For more information on this topic please contact John Baka at (415) 391-2529 or via email: jbaka@hansellcpa.com