One of the first decisions you must make when establishing your business is what structure your business will take. Business structures, such as corporations, partnerships and limited liability companies, are governed by state laws; however, federal tax law determines whether your corporation is eligible for special tax status as as an S corporation. Shareholders in S corporations include the corporation's profits and losses on their personal income taxes rather than the corporation; thereby, avoiding the so-called "double taxation." Federal law also determines the types of compensation available to S corporation shareholders and officers.
Shareholders as Employees
Shareholders can be uninvolved investors, but S corporations often have shareholders who are also officers of the company. For example, a family-owned construction business that includes the father, mother and son as shareholders might also have the father as president, mother as secretary/treasurer and son as vice president. When shareholders act as officers, they must receive compensation for their services as employees of the corporation in the same way they would receive compensation if they were not shareholders. However, officers who do not perform any services or perform only minor services are not necessarily entitled to compensation or considered employees of the corporation.
Amount of Compensation
You must provide reasonable compensation for your S corporation’s employees. The amount of compensation that is “reasonable” depends on such factors as the employee’s duties and responsibilities, training and experience, and what comparable businesses pay for similar services. There are no specific guidelines for determining reasonable compensation, so courts consider the facts and circumstances of each case independently. Compensation must first be made in the form of wages before non-wage distributions may be given to employee-shareholders. In other words, if you give money to someone as compensation for services he provides to the corporation, the compensation is considered wages.
Health Insurance as Wages
Your S corporation can provide a portion of your officers’ compensation in the form of payment of health insurance premiums. As long as the employee-shareholder owns more than 2 percent of your corporation’s stock, health insurance benefits are not subject to Social Security, Medicare or unemployment taxes, though they must be noted on the employee’s W-2 form. Depending on the employee’s health insurance situation, your corporation’s payment of his insurance premiums may provide a significant source of untaxed compensation.
Shareholders who are also employees of the corporation must pay employment taxes even when compensation is paid in a form other than wages, such as through distributions or dividends. If you don't pay compensation as wages but erroneously as something else, the IRS can deem that compensation to be wages after the fact and charge employment taxes on the amount that should have been considered wages. In one Tax Court case, the court held that the sole director and shareholder of a veterinary clinic was an employee of the clinic even though he took his compensation as distributions of the corporation’s net income rather than as wages. As an employee, his distributions were subject to federal employment taxes.