Introduction
S corporations are required to annually file Form 1120S, U.S. Income Tax Return for an S Corporation, although they generally are not subject to federal income taxes. Instead, an S corporation passes its profits and net losses to the shareholders, who are required to report the items on their individual income tax returns. This distribution of the flow-through income, deductions, and other items are reported to the shareholder and the Internal Revenue Service on Form 1120S Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc.
S corporation is one of the fastest growing types of business entities and the most common type of corporate entity filing returns with the IRS. It also offers several attractive benefits to its shareholders. As pass-through tax entities means that profits are subject to tax at only one level. Organizing a business as an S corporation allows shareholders to avoid double taxation on business profits with limited liability protection. In addition, S corporations have the legal capacity to flow through business losses, within limitations, to their shareholders which can be used to offset their taxable income from other sources, such as salaries and wages.
FICA tax is imposed only with respect to employee wages and not on distributive share of shareholders. If shareholder-employees are not paid a “reasonable” wage for the services they perform for the S corporation, the IRS may re-categorize distributions paid for wages.
Tax advisors can find themselves in a tight situation when serving S corporation shareholder-employees in determining amounts to report as compensation and distributions. Understandably, clients want to minimize compensation in favor of distributions to avoid payment of employment taxes. While the governing authority on determining reasonable compensation is growing, it doesn’t really offer