Tax Considerations as a Solo S-Corp Owner and Shareholder: Reasonable Compensation

Introduction

As a solo S-Corp owner and shareholder, managing your personal and business finances can be a complex task. Particularly when the majority of your income consists of business profits (K-1) rather than salary (W-2), it's crucial to navigate the tax implications carefully. This article delves into whether you're still considered employed, the risk of an IRS 'Reasonable Compensation' audit, and how to structure your business expenses and income legally.

The Employment Status and IRS 'Reasonable Compensation' Audit

Given the nuanced nature of S-Corporations and the flow-through of income to the personal return, it's often confusing whether one is still considered an employee when they are the sole owner and shareholder. However, the Employee-Owner status remains relevant, particularly when it comes to Reasonable Compensation considerations.

As an S-Corp owner, you are legally considered an employee, even if you are the only one working for the company. This means you must pay yourself a reasonable salary, and any expenses you have paid on behalf of your corporation need to be reimbursed. The IRS generally takes a keen interest in 'Reasonable Compensation' audits, especially with the advent of the new Section 199A, which may be catching the attention of tax auditors. If the IRS determines that your compensation is not reasonable, they may reclassify your K-1 income as wages, with severe consequences. Therefore, it is advisable to consult a CPA or tax attorney to ensure compliance with tax laws and regulations.

Example Scenario

Consider a scenario where John, a solo S-Corp owner, generates $100,000 in K-1 income but takes no salary, instead drawing all profits as distributions. John's risk of triggering an IRS 'Reasonable Compensation' audit is significantly higher in this situation. The IRS may view John's actions as deliberate evasion of payroll taxes and related benefits, leading to potential penalties and back taxes.

Tax Implications of Not Paying Reasonable Salary

Not paying yourself a reasonable salary can lead to various tax implications and audit risks. Income that is not designated as salary and instead is reported as distributions can be scrutinized by the IRS. This could result in the reclassification of your K-1 income as wages, subjecting you to additional payroll taxes, including Social Security and Medicare, which can significantly hike your tax bill.

In addition, the lack of substantiated payroll expenses can lead to disallowance of deductions. For instance, if you claim that certain business expenses are reimbursable, the lack of documentation can result in the IRS questioning the necessity and legitimacy of these expenses. A well-documented salary can provide necessary proof for your tax returns and legally justify the use of funds.

Consulting a CPA or Tax Attorney

To navigate the complexities of S-Corp taxation, it's crucial to seek professional advice. A Certified Public Accountant (CPA) or a tax attorney can offer expert guidance on structuring your income and expenses, minimizing risk of audits, and ensuring compliance with tax laws.

A CPA can help you determine the appropriate amount of salary for your position based on industry standards and your company's financial health. They can also assist in preparing and filing your tax returns, ensuring all necessary documentation and deductions are accounted for. A tax attorney can provide legal support to protect your interests and minimize the risk of audits and penalties.

Conclusion: When you are the sole owner and shareholder of an S-Corp, it is essential to pay yourself a reasonable salary to avoid an IRS 'Reasonable Compensation' audit. Consistent documentation of expenses, consultation with a CPA or tax attorney, and a comprehensive understanding of your tax obligations will help you avoid potential pitfalls and ensure long-term financial stability.