Taken from the following article:
If you’re a business owner, it’s common to think you can pay yourself whatever you want, whenever you want (as long as the money’s there). It’s your business after all, right?
Well, as with most questions that involve the IRS: it’s not that simple. If your business has elected S Corporation status with the IRS, and you perform services for your business, the IRS actually requires you to take reasonable compensation in the form of income that will show up on a Form W-2 at year-end.
Why Does the IRS Care?
As the common saying goes, follow the money. As an S Corp owner, you re not required to pay Social Security and Medicare taxes on distributions; but you are required to pay these taxes on a W-2 salary. So obviously the IRS wants to collect these taxes on your compensation.
In a broader sense, by electing S Corporation status, you have differentiated yourself from your company by making the company a separate entity, or corporation. Therefore your services to the company are done as an employee, for which you should be paid a wage. Owner distributions should be paid as a result of profit generated by the company, after all expenses (including your W-2 salary) have been paid.
What Is Reasonable Compensation?
This is an important term to know. The IRS wants you to pay yourself the market salary that you’d pay someone else to do your job for you. This salary amount can be based on market data, industry norms, and your own experience. It can be a pretty gray area, so check with your CPA and other financial advisers to make the best decision.
Your Biggest Risk
The biggest risk you can take as an S Corp owner-employee is to take no salary at all. This is a red flag for the IRS and increases your chance for an audit. In the case of an audit, the IRS will likely choose a salary for you that is more generous than you would have allocated for yourself, thus requiring more Social Security and Medicare taxes to be paid, not to mention steep penalties and interest. Therefore it’s best for you to decide your own salary and lessen the chance that the IRS will step in and decide it for you.
So above all else, don’t leave a big fat goose egg on the officer compensation line of your S Corp tax return.
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