You created an S Corporation in which to run your business and it offers some tax advantages as well as a wall between your business and personal assets. However, you are hearing that you need to take a salary from your corporation when in the past you just took the money earned from your business account into your personal account….why do I now have to become a W2 employee of my corporation?
You are now a separate legal entity and have to act as such even though you are not big, you have to follow the rules as if you were. The IRS does not want you to avoid payroll taxes by taking everything as a distribution of income. No large corporations do that, so you can’t either. “Reasonable Compensation” is the term you need to concern yourself with. The IRS wants to see wages on line 7 of your corporate return if you are the owner and an employee of the corporation. Line 7 is officer wages and unless you can say you own the corporation but do not work at it at all, you need to show wages on this line. “Reasonable Compensation” has never been defined, so we use a few rules of thumb to try and determine what would be considered reasonable for your position with the company.
If you take no wages from your corporation, you do not pay into Social Security and thus will reduce your earnings history for when benefits would be due you. I know, I know, we do not know if Social Security will be around forever, but you want an earnings history if you want to get the most out of the benefit that will be due you.
If you take no wages, then you cannot fund any retirement plans because retirement plans like a SEP, 401(k), a SIMPLE are based on earned income and earned income is income on which you have paid payroll taxes. So you need wages to get any retirement funding.
So reduce your risk of getting audited and having your distributions be reclassified as wages. Penalties and interest on reclassified wages form 3 years ago and forward will be VERY expensive!
We can help you determine what “reasonable compensation” is and discuss further how to make your S Corporation work harder for you. Give us a call and let us work with you. firstname.lastname@example.org