In recent years, the Internal Revenue Service (IRS) has increased its scrutiny of S corporations regarding reasonable compensation.
When you do business as a sole proprietor or as a partnership, the profit that flows out to your individual tax return is subject not just to income tax, but to self-employment tax as well. The self-employment tax rate is 15.3 percent. This funds your Social Security and Medicare accounts and substantially increases your tax liability. If you incorporate your business, making it an S corporation, any profit that passes through to your individual tax return is subject only to income tax. You do not pay self-employment tax on those proceeds.
There is a significant financial benefit to incorporating your business. However, it is not as simple as it appears. Many S corporation shareholders wrongly believe they can take a small salary or no salary at all and let the entire profit of the business pass through to their individual tax returns, at a considerable tax savings.
However, the IRS dictates that compensation must be reasonable. How it determines whether compensation is reasonable depends on the facts and circumstances. For example, if your business is experiencing tough times and you are using savings and other earnings to live on, you will likely have little or no W2 earnings from the business. If this is the case, the IRS is not likely to be concerned. However, if you have a successful business with significant profits but little or no W2 income, the disparity between the two items of income is likely to raise questions and lead to IRS scrutiny.
If your compensation is found to be less than reasonable, the IRS will recategorize the income and you will be subject to additional tax. Penalties and interest will also be levied, and it is possible that an audit could be triggered.
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