The QuesUon 01 Payment For $ Corporations' Owners

Nation's Business, Sept, 1998 by Gloria Gibbs Marullo

If you own an S corporation, you have two ways to pay yourself: salary and distributions. As a general rule, S-corporation owners strive to minimize salary and maximize distributions because a loophole in the tax law exempts distributions from employment taxes. But beware. An overly aggressive approach to paying distributions can trigger an Internal Revenue Service audit.

Salaries and bonuses paid by an S corporation are classified as wages subject to employment taxes. But distributions are considered a return on investment and are not subject to employment taxes. The IRS is quick to challenge distributions as disguised wages.

"What's at stake," explains Jeff Pannell, a partner and CPA with Clark Nuber in Bellevue, Wash., "is the FICA taxes on the distribution reclassified as wage income."

For S-corporation owners and self-employed individuals, the FICA (Federal Insurance Contribution Act) tax this year totals 15.3 percent on the first $68,400 in wages. (The Social Security tax is 12.4 percent, and the Medicare tax is 2.9 percent. There is no wage ceiling on the Medicare tax.)

For example, an S-corporation owner pays herself $60,000 in annual salary. On that amount, she and the corporation pay combined FICA taxes of 15.3 percent, totaling $9,180. She takes a $20,000 distribution as a dividend on the stock she owns in the corporation. Because the distribution is exempt from employment taxes, she saves $3,060 in taxes (15.3 percent of $20,000).

"Unfortunately," says Woody Smith, an IRS agent in Indianapolis, "the shareholders of many small S corporations tend to see distributions as an opportunity to reduce FICA taxes. So when we look at the line for officers' compensation on an S-corporation return and see a shareholder who works 100 percent of his time in the corporation, takes a salary of $5,000, and has distributions of $60,000, we're going to get curious.

The agency has a long-standing interest in examining 5corporation distributions closely. In a landmark case that set the governing precedent, a lawyer set up his practice in 1982 as an S corporation, and, as sole shareholder and only employee, he took a distribution of $18,225 but paid himself no salary The IRS challenged the distribution, arguing that it was disguised wages. The courts agreed, and an important precedent was set.

"The key to avoiding problems with the IRS," says Mark Christopher, a CPA and senior tax partner with Moss Adams in Seattle, "is to set a reasonable salary." Typically, reasonableness is determined by looking at the salaries of business owners of similar companies that are not S corporations. (See "Setting The Size Of Your Paycheck," July.)

Christopher advises the owner-employees of profitable S corporations to use the Social Security FICA limit as a rock-bottom guide for salary. "If you pay yourself at least $68,400 in 1998," he says. "I doubt you'll raise red flags with the [IRS]."