Wages and Distributions
Since an S Corporation is a small business, many shareholders perform work for the company that a hired employee would normally undertake. When a shareholder performs these types of tasks, the IRS expects that he will be paid reasonable compensation. If a shareholder is viewed as an employee of the business by the IRS and he receives no compensation other than property distributions, a portion of that amount will be taxed as ordinary income. The IRS is more likely to consider a shareholder an employee if he is an officer in the company, such as the CEO.
When deciding how much of a distribution should be classified as reasonable compensation, the IRS will consider the tasks that the shareholder-employee performed in relation to the business. If the majority of the corporation’s income was generated by the shareholder-employee’s services, then the majority of the distribution will be classified as wages. The IRS will also consider the administrative work that the shareholder-employee did for the business. This is especially relevant for corporate officers. In the case of administrative positions, the IRS will determine reasonable compensation for the shareholder-employee based on several factors, including the shareholder’s responsibilities, experience and what employees earn in similar positions at other businesses.
A person’s stock basis in an S corporation reflects the shareholder’s after-tax interest in the business. The proper application of basis prevents investors from being taxed twice on their investment in an S corporation. To calculate a shareholder’s basis, you start with the original amount of your investment. This includes any cash or property you contributed to start the business. Next, you add any business income you paid taxes on in the past. Then you deduct the amount of any distributions you’ve taken in the past and any corporate losses and deductions you’ve claimed on your income tax returns in the past. What remains is your stock basis in the business.
Generally, any distribution received by an S corporation shareholder is not taxed. First, you subtract the amount from the distribution that was reclassified as wages. The wages portion will be taxed as earned income. If what remains is greater than your current basis in the business, that difference is taxable. The distributions that exceed the basis are normally taxed as a long-term capital gains.