When S Corporation Owners Go Too Far In Saving Payroll Tax
Some owner-employees of S Corporations believe they have a way to beat the payroll tax. Their idea is to pay themselves little or nothing as salary. The S Corporation's profit—higher since not reduced by their salary—is taxable to them (as of course salary would be). But there's only an income tax, with no employment tax due from them or their S Corporation on pay not taken, or so they believe.
IRS will attack this scheme, which it can often detect just by looking at the S Corporation's return. One tip-off is a low or zero number for "Compensation of officers." Another is the entry for "Loans to shareholders"—since funds owner-employees withdraw to live on are called "loans."
IRS typically then says that the amount owner-employees withdraw (as profits or loans), or the amounts on the books as S Corporation profits, are salary subject to employment tax (as well as income tax). And penalties may be added, for negligence or failure to collect and pay over employment tax.
Such a fate befell a lawyer in a recent case, who had borrowed from his S Corporation law firm instead of drawing a salary. IRS and the courts said the loans were wages subject to employment tax, and slapped on a tax penalty for failure to collect and pay over employment tax. IRS went a bit easier on an S Corporation owner-employee in another recent case. This time it looked at statistics on pay in comparable businesses in the area and used an amount so determined as the pay subject to employment tax. This was less than the S Corporation's earnings; the difference escaped employment tax. The court went along with this approach.
Tax advisors who are consulted in advance will advise owner-employees to take some salary, at the low end of what's reasonable, to pre-empt an IRS claim that the S Corporation profit is really salary too. In this case, the IRS used its own definition of reasonableness, after the fact, a definition gentler on the S Corporation than IRS often is.
Could be that a salary figure in this case, arrived at beforehand with a tax advisor's guidance on what IRS examining agents will let stand as reasonable, would have gone unquestioned.
You should consult a tax professional when applying any of these tax planning suggestions.