A major issue for most S corporations is the matter of shareholder compensation and benefits. One of the advantages of an S corporation is the ability to avoid self-employment taxes on the earnings of the corporation. However, payroll taxes cannot be totally avoided as the IRS requires that an employee/shareholder be paid a “reasonable” salary. A related issue is benefits made available to the shareholder/employee. There are restrictions on benefits that shareholders can receive. These shareholders often do not realize (or choose to ignore) that the corporation cannot be treated like a gift bag in which you reach in and give themselves personal benefits.

A shareholder/employee is required by law to receive a “reasonable” salary from the corporation. The IRS does not define reasonable but takes into consideration several factors. The salary must be commensurate with salaries paid comparable executives in similar situations. However, the earning history of the corporation and unusually low salaries received in the early years of the business may be taken into consideration. If the IRS deems the salary too low, the IRS may treat distributions to the shareholder as salary. This, of course, affects the tax liability of both the corporation and the shareholder. Conversely, if the IRS deems the salary to be excessive, it will be recast as a distribution which also affects the tax liabilities of both entities.

Whatever salary is paid to shareholders, it must be paid for services actually rendered – you don’t get a salary just because you are a shareholder. This salary is subject to withholding and payroll reporting. In this regard the shareholder is treated like any other employee. The salary amount should be approved by the board of directors of the corporation.

Benefits paid to a shareholder/employee who owns more than 2% of the stock of the corporation generally will be taxable compensation. In addition, the board of directors must approve any of these benefits conferred upon the shareholder. Taxable benefits may be reported on box 14 of the W-2 and are not subject to employment taxes. Therefore, they must be included as salaries and wages in box 1 of the W-2 but not boxes 3 and 5.

A benefit is any non-business related item given to an employee/shareholder. This would include any personal obligations of the shareholder paid by the corporation. Examples would include the corporation paying the monthly car payment for the shareholder’s vehicle, the shareholder using corporate property for his/her personal use, or any other use of corporate assets for the benefit of a shareholder. It is extremely important that personal and business transactions be kept separate and never mingled.

Related to benefits paid to shareholder/employees is the issue of paying benefits to shareholders who are not employees. For example, it is possible for the corporation to pay the health insurance costs for a shareholder. However, this creates a number of problems as the cost of the insurance is considered a distribution to the shareholder. Assuming that not all shareholders received the identical benefit, this is then classed as a disproportionate distribution and may create difficulties with the IRS, including loss of S corporation status.

Once again we return to the familiar refrain “Keep corporate and personal transactions separate.” Keep a separate bank account for the business, pay only business obligations from the business checking account. Document board authorization for compensation paid to a shareholder. Keep good records, and you will have a better chance to prove your compliance with these rules and regulations.

In accordance with Circular 230 Disclosure