Navigating Low Salaries and High Distributions in S-Corporations: A Comprehensive Guide

Many S-Corp owners wonder if they can legally pay themselves a high hourly wage while taking a relatively lower amount of income as wages and a larger share as distributions. This article will provide a detailed guide on how to navigate this complex scenario and ensure compliance with IRS regulations.

The IRS’s Expectations for Reasonable Compensation

The IRS requires that S-Corp shareholders who provide services to the corporation be paid a reasonable salary. This mandate applies to anyone who is an employee of the S-Corp. The reasonableness of the salary is typically based on industry standards for similar roles. If you significantly reduce your working hours, a lower salary can be justified, but it must still align with industry benchmarks.

Understanding the Difference between Distributions and Salaries

While S-Corporations can distribute profits to shareholders, these distributions should not be used to avoid payroll taxes. If the salary is deemed unreasonably low, the IRS may reclassify some distributions as wages, leading to back taxes and penalties. This highlights the importance of maintaining accurate records and justifying your salary based on industry standards and the work you perform.

Documentation and Evidence

To support your claim for a lower salary, it is crucial to maintain meticulous records and timesheets. These documents should accurately reflect the work you perform and align with the compensation norms in your industry. High-quality documentation can be invaluable during an IRS audit, especially if your working hours are significantly lower than what might be expected based on the amount of work you perform.

Potential Audit Risks

If your salary is significantly lower than industry norms, there is a high risk of triggering an audit. The IRS is known to scrutinize compensation structures, especially when distributions are much higher than salaries. Therefore, any discrepancies need to be thoroughly justified and supported by solid documentation. The risk is amplified if your so-called timesheets are as precise as you claim. Remember, the IRS is well-equipped to spot inconsistencies and discrepancies.

Consulting with a Professional

The complexities involved in determining reasonable compensation make it wise to consult with a tax professional or an accountant who has experience with S-Corporations. They can provide tailored guidance to ensure compliance with IRS regulations. Professional advice is crucial to navigating this area effectively and minimizing the risk of penalties or audits.

Conclusion

While it is possible to take a lower salary and a larger share of income as distributions, such arrangements must be justifiable and reasonable based on the work you do. Proper documentation and professional advice are essential for navigating this area effectively. Ignoring these guidelines could lead to significant financial and legal complications.