Tread carefully when determining compensation for S-corporation shareholder-employees.
By distributing profits in the form of dividends rather than salary, an S-corporation and its owners can avoid payroll taxes on these amounts. Because of the additional 0.9% Medicare tax on wages in excess of $200,000 ($250,000 for joint filers and $125,000 for married filing separately), the potential tax savings may be even greater than it once would have been. (S-corporation dividends paid to shareholder-employees generally won’t be subject to the 3.8% net investment income tax.)
But paying little or no salary to S-corporation shareholder-employees is risky. The IRS has targeted S corporations, assessing unpaid payroll taxes, penalties and interest against companies whose owners’ salaries are unreasonably low.
To avoid such a result, S corporations should establish and document reasonable salaries for each position using compensation surveys, company financial data and other evidence.