S-Corporations are the preferred entities for any small, closely held active business.  The reason for this preference is due to the ability to place a ‘cap’ on the social security paid for the corporation’s owners.  S-Corporation owners only pay social security on wages paid, as compared to self-employment taxable entities such as sole proprietorship and partnerships who are required to pay social security on the entirety of the business profits.

The effective use of an S-Corporation can save thousands of dollars to a profitable business.  

There is, however, one key factor in avoiding IRS scrutiny.  The S-Corporation cannot pay unreasonably low wages.  The Internal Revenue Service will see this as tax avoidance, and re-characterize non-taxable profit distributions and payments subject to social security.

How much compensation is ‘reasonable?’  The IRS provides no clear guidance.  Our firm uses the following definition:

“Reasonable Compensation is what you would pay someone else to do substantially similar work.”

IRS factors taken into account include: employee duties; the amount of time spent working; ability and accomplishments; complexities of the business; gross and net income; compensation history; and salary policy for all employees.

Proving reasonable compensation can be accomplished using the following actions:
– Set compensation annually in the Board of Directors meeting and record them in the annual minutes
-Avoid paying compensation in proportion to stock (which is viewed as a disguised dividend)
-Be aware of what your competition is paying.
You should review compensation on an annual basis.  To schedule an appointment to review your compensation, please click the link below.

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