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S Corporation CPA discusses shareholder-employee compensation | IRS Form 1120S CPA

CPA Wilmington NC discusses IRS Form 1120-S compensation issues

Gary Bode, CPA: for a free initial phone consult, please call us as 399-2705.

S Corporation CPAs know S Corp employee-shareholders live with an IRS dilemma. Why? They receive a mix of salary and distributions as compensation. S Corporation dividends don’t incur employment taxes, saving the S Corporation 7.65% of Social Security and Medicare taxes. S Corporation dividends don’t incur self-employment taxes, so the shareholder-employee also saves 7.65% by not having their Social Security and Medicare taxes with held.

The IRS prefers more salary because it incurs the 15.3% of Social Security and Medicare taxes split between the employee-shareholder and S Corporation.

In my experience most S Corp employee-shareholders don’t believe Social Security will help their retirement. So, employee-shareholders and the S Corp want the highest distributions and the lowest salary possible.

This is a Form 1120S loophole your CPA can exploit, but it’s also the thrust of IRS tax audits. And in a tax audit, the IRS can re-characterize shareholder-employee distributions as wages, triggering years of back payroll taxes. Worse, the IRS is in the process of performing highly publicized tax audits of IRS tax Form 1120S returns to look at this issue. So, wages and distributions deserve careful structuring.

“The IRS explicitly expresses interest in the distribution to wages ratio for S Corporation shareholder-employees. There is no employment or self-employment tax on Form 1120-S distributions. They expect some wages, but don’t provide clear rules on the amount.”
– Gary Bode, Form 1120S CPA

Form 1120-S Perspective: Distributions vs. Wages

Non-wage distributions to shareholders are subject to income tax on IRS Form 1040, but not to self employment tax. Up to the annual Social Security salary cap of $117,000, every $1,000 of distribution, compared to wages, saves the S Corporation $76.50, and the employee saves $56.50. After the first $117,000 of annual wages, each $1,000 of distribution saves the Corporation $14.50 and the employee $14.50.

Here’s a link to a Form 1120-S compensation strategy to save on taxes, at least every other year.

IRS Guidelines for Form 1120-S Tax Audit

No absolute IRS Form 1120-S guidance on shareholder-employee wages exist. It’s truly a  gray area. But the IRS looks at the following factors on a case by case basis during a tax audit;

  • The shareholder-employee’s qualifications.
  • Comparison to salaries paid by similar firms.
  • Employee’s responsibilities.
  • Salary/distribution ratios.
  • Salary compared to available cash flow.

Proactive Documentation for Form 1120-S Compensation

The corporate minutes should proactively document, through corporate minutes, the factors influencing the setting of salaries of shareholder-employees.

State Tax Forms

Remember to consider the State implications on all S Corporation tax issues.

I’m a Form 1120S CPA operating as an S Corporation. So you know stay sharp on Form 1120S developments. Our virtual office allows us to offer excellent client service to long distance clients and greater convenience for our local Wilmington NC clients. Please read a few posts to better gauge our ability. We offer a free initial phone consult on any Form 1120-S tax issue. (910) 399-2705.

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