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S Corporation Strategies Using Shareholder Wages

S Corporation Strategies Using Shareholder Wages

By Sue Bosevich

Due to the flexibility of distributions and the lack of double taxation, S corporations enjoy more tax planning opportunities through the manipulation of shareholder wages. The manipulation of shareholder compensation to accomplish tax-savings objectives can be risky. The better the documentation (e.g., in the corporate minutes) and the greater the business purpose for such transactions, the more likely the transactions will withstand IRS attack. In any case, the compensation to the shareholder-employee must be reasonable for the services rendered.

Since substantial tax advantages can be gained by S corporations using compensation to achieve certain objectives, a significant portion of IRS activity in the S corporation area is directly or indirectly related to the reasonableness issue. Those areas, discussed in the following paragraphs, are:

  •  Reallocation of S corporation income among family member
  •  Minimizing salaries to reduce payroll taxes
  •  Using compensation to minimize built-in gains and passive investment taxation
  •  Reducing salaries to change character of shareholder’s income

Reallocation of S Corporation Income among Family Members

One method of shifting S corporation income is to reduce the salary paid to the owner. This increases the corporation’s net income and shifts pass-through income to the other shareholders, who are often children in a lower tax bracket.

In addition to shifting income to a lower tax bracket, the pass-through income increases the stock basis of all shareholders, in accordance with their stock ownership, which in turn allows a corresponding nontaxable distribution from the S corporation.

If the IRS feels that compensation for services rendered or for capital furnished is unreasonable (i.e., too high or too low), the IRS will reallocate income among family members to properly reflect the value of such services or capital. Included among family members are spouses, ancestors, lineal descendants, and trusts created for such persons.

Minimizing Salaries to Reduce Payroll Taxes

Since draws are not subject to payroll taxes or self-employment tax, shareholders and the corporation can reduce or eliminate social security and unemployment taxes if the shareholder receives draws instead of salary. However, if the payment to the shareholder actually represents compensation for services rendered to the corporation, the payments are not distributions but instead are wages subject to withholding. The IRS is well aware of this strategy for reducing or eliminating employment taxes. Reportedly, some IRS Service Centers have their computers programmed to detect those S corporations who report relatively small salaries in relation to distributions.

Using Compensation to Minimize Built-in Gains and Passive Investment Taxation

Certain S corporations are subject to tax at the corporate level under the built-in gains tax and the passive investment income tax rules. These taxes are deferred or eliminated if the corporation has no taxable income, determined as if the corporation were a C corporation. Therefore, a common tax planning strategy is to increase owners’ salaries or make year-end bonus payments to eliminate the taxable income and thereby eliminate these taxes. For this strategy to work, the total compensation paid, whether as salary, bonus, or some other form, must be reasonable.

Reducing Salaries to Change Character of Shareholder’s Income

Distributions from an S corporation may be:

1. Taxable as ordinary income [if considered to be distributions of C corporation accumulated earnings and profits (AE&P)];

2. Nontaxable (to the extent of the shareholder’s basis if the corporation does not have AE&P); or

3. Capital gain income (if the distributions exceed the shareholder’s stock basis and the corporation does not have AE&P).

Since wages are always ordinary income, the character of the shareholder’s income can change if the corporation reduces the shareholder’s salary and makes distributions to him or her instead. If this is done, the corporation should be able to substantiate good business reasons for the salary reduction.

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