S Corporation Service Firm Owners Beware

Income Tax

S Corporation owners who are service providers often take a low salary so that they can receive most of the firm’s profits as a dividend, avoiding payroll taxes.  When the salary is unreasonably low, or there are no other fee generating employees of the firm, doing so is particularly questionable.  In the December 2010 Watson case, a CPA, whom you think would know better, was busted by the IRS for this practice.  Mr. Watson took a salary of just $24,000 in a year in which his share of the profits was over $200,000.  The U.S. District Court for the Southern District of Iowa ruled for the IRS and held that the compensation was unreasonably low and the dividends were properly reclassified as salary and subjected to payroll taxes.

To be safe, make sure you set a salary comparable to what someone in a comparable position would get, and if you you have no employees who are also bringing in fees, take virtually all of your net income as a salary.  This will help keep in the IRS away, and let you contribute more to your retirement account, as your earned income will be much higher.
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