The Journal of Accountancy (what we CPA’s love to read!) has a very helpful article on
Here’s a few excerpts (for the full article click here) and my plain-English summaries.
…an advantage of an S corporation over a C corporation is that a shareholder’s share of the corporation’s net income is not considered self-employment earnings and therefore is not subject to self-employment tax (13.3% in 2011 and 2012).
(IOW, S corporation status can reduce the Self employment taxes you’ve been paying as a sole proprietor.)
However, if the S corporation shareholder provides services to the S corporation, he or she must receive an adequate or reasonable amount of compensation for these services. The S corporation may deduct the compensation expense and must pay the employer share of employment taxes: 6.2% Social Security tax and 1.45% Medicare tax. The shareholder-employee is responsible for 4.2% Social Security tax (in 2011 and 2012) and 1.45% Medicare tax. The S corporation is also responsible for Federal Unemployment Tax Act (FUTA) taxes. Minimizing these taxes provides an incentive to keep the S corporation shareholder’s wages low and to characterize most of the passthrough income as distributions.
(The owner/employee of the S corp must take a reasonable salary and pay Social Secutity, Medicare and FUTA taxes. Some S corp owners take very small salaries.)
The IRS has the authority to reclassify dividends, distributions, or payments to the shareholder-employee, including loan repayments, as compensation if it deems compensation inadequate or unreasonable.
(The IRS doesn’t like it when you try to take a tiny salary to avoid paying SS/Medicare taxes)
The IRS has posted on its website (tinyurl.com/7kp3yrf) three major sources of gross receipts it will consider when determining reasonable compensation: the services provided by the shareholder, the services of nonshareholder employees, and the capital and equipment of the corporation.
(How to know what’s a reasonable salary? The IRS is here to help!)
Determining if S corp status is right for your business and determining a reasonable salary is where a CPA can really help you (unless you like reading IRS documents!)
Carol Topp, CPA