S-corps Must Treat Working Shareholders as Employees
Profit Ability Article Highlight

James is the owner of a $10 million manufacturing company based in Northern California. James is the sole owner of this S corporation, and therefore reports all of its income on his personal tax returns. Because James was the sole owner, he saw no need to pay himself a salary since he was receiving its income and paying tax on it anyway. By not taking a salary, he and the corporation avoided paying payroll taxes.

However, the IRS objected to James's arrangement, claiming that James was doing work for the corporation to earn his income, so he must receive a wage subject to employment taxes. James countered by saying he shouldn't be considered an employee, for he didn't take instructions and wasn't answerable to anyone. The issue went to the Tax Court where the ruling was given to the IRS. The Court ruled that since the owner worked for his business, he was a "statutory employee," even if he didn't answer to anyone else. So, his income from the business was taxable as wages. S-corporation owners who work for their businesses must receive "reasonable" wages, and though the IRS Tax Code gives no actual definition of "reasonable," regulations provide that "reasonable compensation is an amount paid for like service by a like enterprise under like circumstances."

This case shows the importance of tax planning and proper identification of both corporate and personal taxes. If you would like to ensure your tax structure is within IRS guidelines, we recommend you make an appointment with a Talley & Company tax professional today. You can reach our offices through the contact section.