You may have heard about the IRS crackdown on use of an S corporation to avoid taxes. However, having an S corporation remains a legitimate means for a reducing taxes associated with Social Security and Medicare. Unincorporated business operations pay these taxes as the self-employment tax.
By incorporating and working for your corporation, you receive wages just like any employee. Social Security and Medicare are taxes are incurred on the wages you receive. However, these employment taxes are not assessed on S corporation profit. The amount of business earnings that you don’t pay yourself as wages escapes self-employment taxes.
What bothers the IRS is abuse of this system. Wages that are unreasonably low are reclassified as officer salary. Employment taxes are assessed and late payment penalties. The IRS prohibits S corporation shareholders who work for their companies from receiving all or most of their compensation as distributed profits free of employment taxes. There’s a requirement for shareholders who perform work for their corporations to receive “reasonable” wages.
The tax code doesn’t have an exact definition of “reasonable” wages. But you can attain a defensible salary if it’s based upon compensation that is paid by comparable businesses for similar services.
An important process for most small businesses that are S corporations is payment of salaries to offices that is higher than their tax-free distributions as shareholders. The IRS reasons that your effort as a corporate officer is mostly responsible for generating profits. Therefore, most of the money you receive from your S corporation should comprise wages.
After creating a corporation using the correct process within your state, you only need to send the IRS a simple form to assure federal tax status as an S corporation. This causes assessment on your personal tax return of regular income tax for the corporate profits. There are no employment taxes on the S corporation profit.
S corporation profit has already been taxed on the shareholder. So, distributions are tax-free. Just make sure that the taxable profit is first reduced by reasonable wages that incur both regular income tax and employment taxes.