S corporations and taxes
Many small business owners structure their companies as S corporations, a setup that can lower their tax bills and allow them to protect their personal assets if the company is sued. But owners who try to lower their taxes too much can run into trouble with the government.
S corporation owners typically draw a salary from their companies and also take a dividend distribution. Problems can arise when owners try to save on what are called payroll taxes — Social Security and Medicare withholdings — by paying themselves an unreasonably low salary and pumping up their dividends. The lower their salary, the lower their payroll taxes will be.
Tax professionals say unreasonably low salaries at an S corporation are a red flag to the IRS and could prompt the government to audit an owner’s return — and in the case of multiple owners, their returns as well. If the IRS deems salaries to be too low, it can reclassify dividends as salaries and owners can be forced to pay back taxes, interest and penalties.
The IRS website, www.irs.gov, lists several factors that courts have considered in determining whether a salary is reasonable. Among them: an owner’s training and experience, duties and responsibilities and time devoted to the business. Also, the compensation given to employees who are not shareholders, and the salaries that comparable businesses pay for similar services.