Tax Implications of Establishing an S Corporation

S corporations make an election with the Internal Revenue Service to become known as “pass through” entities. This means that they pass to their shareholders the federal tax consequences of corporate income, losses, deductions, and credits. S corporations therefore differ from C corporations by avoiding double taxation of corporate income.

Owners of S corporations have discovered that employment taxes—such as contributions to Social Security and Medicare—are not incurred on their business profit. Only unincorporated proprietors incur these taxes on their profits by paying  the self-employment tax. This situation is scrutinized by the Internal Revenue Service because some person must operate an S corporation and therefore is an employee subject to employment taxes.

Although payroll taxes aren’t paid on shareholder income, any S corporation shareholder who is also an officer must receive a salary that does incur payroll taxes.

Shareholder Officers

Individuals who perform services as officers of an S corporation must receive compensation as wages just like any employee. This situation isn’t impacted by the existence of corporate officers who are also shareholders of the S corporation. Some of the payment to anyone who is both a shareholder and a corporate officer is regarded as officer salary rather than entirely comprising a distribution as shareholder.

Reasonable Wages

The IRS requires payment of “reasonable” compensation to shareholders who perform services as corporate officers. The general IRS guideline is that most of the payments to a shareholder officer should comprise salary if the majority of the revenue and profit are derived from that person’s services to the S corporation. Other factors considered in determining a reasonable salary are the officer’s duties, responsibilities, training, experience, and effort devoted to the business as well as compensation to non-shareholder employees and amount of payments other than salary to shareholders.

Tax Impact

Court decisions have consistently held that shareholders of S corporations are liable for federal employment taxes when they are also corporate officers. Officer salary incurs the same taxes as wages paid to other employees. The S corporation profit is taxable to the shareholder for regular income tax only, regardless of whether it’s distributed. A distribution from an S corporation is tax-free unless it exceeds the shareholder’s basis. This shareholder basis is formed by the amount of the individual’s investment in the company plus accumulated profits over the years minus past distributions.

Health Insurance

The salary of an S corporation officer who owns more than two percent of the shares is increased by his health insurance premiums paid by the company. This amount is added to wages reported on Form W-2 but is not subject to employment taxes such as Social Security and Medicare. The shareholder/officer includes the amount as wage income on his tax return and then deducts an equal adjustment to income elsewhere on the tax return if the health insurance premiums were paid for a plan established by the S corporation.

Retirement Plans

Another consideration with regard to shareholder compensation is the effect on retirement plans. The only factor affecting the allowed amount of retirement plan contributions is wage compensation. The tax deduction limits for retirement plans are based upon only earned income. For self-employed individuals this is the net earnings of the business. However, S corporation profit passed through to shareholders is not considered net earnings from self-employment.

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