Businesses operating as Subchapter S corporations may want to adjust salaries paid to working owners given the bad economy. Such an adjustment can save the business and its owners thousands in taxes. But this reset of S corporation salary is tricky. The adjustment needs to not violate tax laws about reasonable S corporation wages.
Why Adjust Shareholder-employee Wages?
While adjusting the salary an S corporation pays to a shareholder (especially in a one-shareholder corporation) typically doesn't affect the income taxes that the business owner pays, the salary paid to S corporation shareholder employees does affect the payroll taxes that the S corporation and the S corporation shareholder pay.
Lowering a shareholder's wage often saves payroll taxes equal to about fifteen percent of the decrease. For example, decreasing the annual salary paid to a shareholder-employee by $10,000, might save the business and its owner around $1,500 in federal payroll taxes. And the business and its owner might also enjoy additional state payroll tax savings.
If the reduction in payroll to a shareholder is, well, made up with an increase in the distributions paid to that same shareholder, the salary adjustment reduces only the payroll taxes paid. The shareholder's family income isn't hurt.
Can the Corporation Reduce Shareholder-employee Compensation?
Unfortunately, an S corporation's ability to reset compensation in a weak economy is limited. Tax law says that shareholder-employee wages should be reasonable.
Reducing shareholder wages can be imminently reasonable... but the S corporation would hard put to argue successfully that salaries needed to be reduced by, say, $10,000 per shareholder-employee if at the same time distributions paid to shareholder-employees were increased by $10,000. Sorry. The Internal Revenue Service is not stupid.
However, if distributions paid to shareholders have been dramatically reduced, the S corporation should be able to logically reduce shareholder-employee salaries.
Further, if the S corporation has not made distributions to shareholder-employees during a year, many tax law practitioners (CPAs and attorneys) think that the S corporation can in this special case reduce shareholder-employee salaries dramatically--even down to zero.
The IRS currently takes the position that it may re-categorize distributions as shareholder-employee compensation if the corporation has not paid reasonable compensation to shareholder-employees. However, the IRS can't magically create compensation or increase compensation if no distributions (and no other similar payments) have been made to shareholder-employees.
What to Avoid When Adjusting S Corporation Shareholder Salaries
One other point about S corporation shareholder salaries should be made: In a troubled economy, S corporations want to avoid loaning or contributing additional money to a corporation merely to pay shareholder wages.
Putting money into or loaning money to a corporation and then immediately withdrawing that money in the form of salary doesn't trigger any income tax benefit or cost. But moving money into and out of the S corporation in this manner unnecessarily incurs payroll tax. What makes more sense for a S corporation shareholder is to simply skip both the contribution and the payroll withdrawal.
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