What Not To Do With Your S Corporation

Edith was a licensed real estate agent working as an independent contractor for Coldwell Banker. She put commissions and other income earned as agent into the S corporation she owned. She reported her share (all) of the S corp income, for income tax purposes. She took no salary from her corporation. Instead, she treated any withdrawals she made from the S corp as loans, giving a promissory note.

This, as you will have noticed, means that she paid no employment tax—social security or self-employment tax—on her earnings, and IRS would have none of that indicating she needed to take a reasonable salary for her services to the S corporation. It denied that amounts Edith dropped into her S corp were properly income of the S corp, and the court agreed. She was assigning her personal income to the S corp. But assigned earnings are taxable to the one who earned them. If that earner is self-employed, the earnings are subject to self-employment tax.

The court then spelled out how those earnings could have been made income of the S corp:

(1) She should be an employee of the S corp. She met that test, as president of the S corp. And—

(2) The S corp must have a contractual right to direct her services as its employee. There was no such contract here, so earnings from her services aren’t S corp earnings.

Note: Oral contracts to direct services are technically okay, but professional advisors often recommend and draft written ones. This would be especially true where corporate income derives primarily from services by its owners. The writing is an agreement of one person wearing two hats, signed by the individual as S corp employee and then for the S corp by that individual as its president.

Of course, IRS will expect an S corp owner providing valuable services to be paid reasonable compensation. That pay will be subject to social security tax on employee owner and on S corp.

TIP: Reasonable compensation/reasonable pay need not be everything earned. Tax advisors can suggest what portion of the S corp’s income the IRS or courts will likely accept as reasonable pay. That pay reduces S corp income. The pay is subject to employment tax (social security tax) on the S corp (the deduction for this tax reduces S corp income further) and on the owner-employee. The balance of S corp income, though subject to income tax (on the owner), avoids employment tax.

Edith’s misguided path led to employment tax on all her earnings.