Posted by: Coto Legal Services, PLC | March 17, 2011

Reducing Payroll Taxes- S Corporations

One commonly used tax planning technique used for S corporations is to reduce the owner’s compensation amount, and then increase the owner’s distribution amount.   This technique can be effective in reducing the company’s payroll tax liability because compensation is subject to payroll taxes and S corporation distributions are not.

However, the Internal Revenue Service is aware of this tax planning technique and consequently scrutinizes compensation paid to S corporation employee-shareholders.  If the employee-shareholder’s compensation is unreasonably low, (which is a major audit red flag), and there are S corporate distributions, the IRS will likely re-characterize the S corporation distributions as compensation ( See how S corporation compensation compares to C corporation compensation by reading the previous post).  If the S corporation distribution are re-characterized as compensation,, the company may be subject to substantial taxes, interest and penalty charges.

Compensation must be reasonable, which allows the IRS to determine if the compensation of an employee is reasonable for the personal services that were actually rendered.   The courts have considered the following principal factors to determine the reasonableness of a salary: 1) the qualifications of the employee; 2) the employee’s contribution to the success of the business and 3) how the employee’s salary compares to the salaries of similar employee positions in the same industry.

Additionally,   state tax implications must be analyzed to determine if this payroll reducing technique is effective.  The Michigan Business Tax allows corporations to deduct compensation, but will not allow an S corporation distribution deduction.  So, by reducing compensation to the employee-shareholder, while increasing S corporation distributions, may increase your Michigan tax lax liability.

Consequently, for Michigan S corporations, reducing compensation, while increasing S corporation distributions, may not be effective, considering the state tax implications.

Coto Legal Services, PLC would love to discuss if this strategy is right for you.  Our office will customize strategies to minimize your taxes and protect your assets.  Email us at rcoto@cotolegal.com.  Visit us at our website at cotolegal.com

Information on this blog is not intended to be legal advice.  Visiting this blog does not establish an attorney-client relationship.


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