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S CORPORATION
An S corporation is a corporation that shares many of the same features of a partnership for tax purposes. As a corporation, it has stock, shareholders, and employees. The shareholder-employee can be considered an employee, and their salary and benefits are deductible expenses to the corporation.
An S corporation is similar and dissimilar to a partnership:
| Similarity | Dissimilarity |
|---|---|
| An S corporation is like a partnership in that corporate net-operating income is passed through to the shareholders. | Unlike a partnership, flow-through income from an S corporation is NOT subject to self-employment tax. |
Under-Compensation
A shareholder-employee's motivation to under or overcompensate themselves in closely held corporations is a function of the type of corporation being used.
| S corporation | C corporation |
|---|---|
| There's a desire to under-compensate. | There's a desire to overcompensate. |
Under-compensation is achieved when income is paid via distributions that are based on the flow-through of net operating income without the requirement to pay the self-employment tax. On the surface, this appears to be a clear tax advantage of an S corporation vs. a partnership. However, there's a caveat.
If a shareholder-employee of an S corporation provides services to that S corporation, then reasonable compensation (subject to employment taxes) generally needs to be paid before any non-compensation distributions (i.e. profit) may be made to that shareholder-employee. Several court cases support the authority of the IRS to reclassify other forms of payments made to the shareholder-employee as a compensation expense.
In addition to challenging compensation paid to shareholders, the IRS will challenge compensation paid to members of the shareholders' families. If the compensation for services or for use of capital is not reasonable, the IRS will make an adjustment. This adjustment will also carry through to the recipient of the compensation.
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In an S corporation: