An S Corporation's Board of Directors' Compensation vs. a Shareholder Distribution

By Lee Hall, J.D.

An S Corporation's Board of Directors' Compensation vs. a Shareholder Distribution

By Lee Hall, J.D.

An S corporation has 100 or fewer shareholders. It is a small business, often held by a group of family members or close personal associates—or perhaps even a single person. Distributions to shareholders are tax-exempt on the corporate level. The shareholders declare their shares of corporate income and expenses on their personal returns. Because of this "pass-through" dynamic, the corporation avoids double taxation. At the same time, individual officers and directors should receive taxable compensation for services performed.

Three businesspeople gathering around table

Addressing the Corporate "Double Taxation" Problem

Many entrepreneurs, limited liability companies, and C corporations elect for taxation under Subchapter S of the Internal Revenue Code rather than their default tax provision, such as Subchapter C for a traditional C corporation. Beyond offering the liability shield that the corporate status brings, the S corporation allows for partnership-style taxation on income generated by the corporation.

A traditional C corporation first pays corporate taxes on its income. After that, any profits that remain become retained earnings. The business may distribute these to its shareholders, who in turn pay tax on their dividends individually. This is the problem of double taxation that the creation of the S corporation sets out to solve.

By electing tax treatment under Subchapter S, the business becomes, for tax purposes, a "disregarded entity" that need not pay federal taxes. The business profits and losses "pass through" to shareholders' individual tax returns, with tax applied according to each individual's income tax bracket.

Issues to Watch

The tax status of the S corporation compels it to allocate profits to shareholders every year. Yet the federal tax code does not compel the distribution of the shares. Because profits or losses, which the S corporation declares annually for tax purposes, need not be actually distributed, the individual taxpayers may have tax obligations for profits that they have yet to receive.

Moreover, note that taxable events can still occur after the Subchapter S election, such as taxable dividends issued out of retained earnings from the business prior to a changed tax status election or capital gains from stock sales.

Distinguishing Compensation from Distributions

Shareholders hire the board of directors to set out the strategy for the corporation, and the CEO and other officers manage corporate affairs accordingly. Their compensation comprises a certain portion of the directors' and officers' annual gross income for tax purposes, distinguishing salary payments from shareholder distributions, which are not taxable events.

After the business pays all expenses including salaries, each shareholder, including the directors, receives a share of the profit or loss. The expenses before distribution include salaries and other compensation to remunerate the S corporation's board and officers for their services. This compensation is separate and distinct from the shares they might then receive.

The Internal Revenue Service (IRS) regards compensation for duties performed as the earning of wages. Thus, an S corporation's compensation to a director involves income tax and other standard withholdings. It falls under the Federal Insurance Contributions Act, subject to FICA tax, and also the Federal Unemployment Tax Act, subject to FUTA tax.

Required Taxable Compensation

If S corporation shareholders perform anything over and above minor services for the business, they are entitled to compensation—that is, wages. Indeed, courts deem shareholders as subject to federal taxation even when they accept distributions in lieu of wages.

What if an employee-shareholder takes a small income but large distributions? In such a case, the court may find the compensation unreasonably small. The test is whether the S corporation is paying true remuneration for services performed.

The S corporation must also avoid disguising compensation as loans to any sole shareholder, board member, or officer. The IRS states that when an S corporation's shareholder receives or is entitled to money or property, the business must determine and declare a reasonable salary for that person.

Overall, qualifying for tax treatment under Subchapter S may benefit a business. At the same time, the S corporation model upholds the IRS provisions that distinguish board members' salaries from shareholder distributions.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.

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