There is no one-size-fits-all answer for closely held corporations when choosing to be taxed as an S-Corp or a C-Corp. Certainly, one of the factors driving the choice between classification as an S-Corp or C-Corp is that everyone wants to pay less in taxes. As a result, shareholder-employees of these companies will often try to reduce their tax liability by adjusting how much is paid to such shareholders in the form of wages.
Since an S-Corp passes through its income to its shareholders, shareholder-employees of S-Corps are often incentivized to pay to themselves as little wages as possible to avoid Medicare and Social Security taxes (e.g., this type of tax planning is often seen as implemented by physician practices. Conversely, a C-Corp is subject to double taxation in which the company pays a corporate level tax of 21% (under the Tax Cuts and Jobs Act) and the shareholders are taxed again on dividends. As a result, and in order to avoid this double taxation, closely held C-corps, such as physician practices, often try to “zero-out” the C-Corp’s income by paying the shareholder-employees all of the company’s “profits” as wages. It should come as no surprise that this strategy is nothing new, and regardless of whether the corporation is taxed as an S-Corp or C-Corp, the IRS requires the compensation to shareholder-employees to be “reasonable.”
An S Corporation must pay reasonable compensation, which is subject to employment taxes, to a shareholder-employee in return for the services that the employee provides to the corporation, before non-wage distributions may be made to that shareholder-employee. Failure to claim an adequate amount in wages could result in the IRS characterizing non-wage distributions as compensation in a subsequent audit resulting in additional compensatory income to the shareholder-employee (subject to ordinary income tax rates and employment taxes).
Unlike S-Corps’, C-Corps often try to over claim wages to shareholder-employees, and try to zero-out profits. This “zero-out” tax planning strategy may only be used to the extent that the compensation is reasonable to the shareholder-employee, as compared to compensation received by similarly situated employees (e.g., physicians) for similar services. As a result, businesses that generate significant income from goods or services not directly related to the services of the shareholder-employee(s) should not pay out all of the excess income to the shareholder-employee as wages (e.g., a year-end bonus).
For new companies, understanding what a reasonable compensation will be is essential when assessing the proper election for your company. For existing companies, it is important to ensure that the compensation for shareholder-employees remains reasonable as the business grows.
For more information or if you have any questions, please contact Peter J. Domas in the Ann Arbor office at ext. 7595.