S Corporation Requirements
Like traditional corporations, called C corporations, S corporations offer liability protection for the owners, called shareholders. Under the corporate structure, shareholders are not personally liable for the business’s debts merely because they invested in the corporation. However, in an S corporation, corporate profits and losses flow through to each shareholder’s personal taxes. This avoids the double-taxation problem in which C corporations are taxed at the corporate level as well as the individual level. To take advantage of S corporation tax privileges, the corporation must qualify for this status in accordance with IRS regulations. For example, you cannot have more than 100 shareholders or more than one class of stock.
Shareholders as Employees
When your corporation’s shareholders perform services for the company, they are also considered employees and must be compensated as such. For example, if you are both a shareholder and the company’s president, you may receive distributions in the same way that other shareholders receive distributions. However, you must also receive compensation for services provided as president in the same way other employees receive compensation. Bonuses or corporate distributions cannot be used as substitutes for receiving a salary.
Though it may be tempting to bypass payroll taxes by taking your compensation in some form other than a salary, doing so can create significant tax penalties. The IRS requires corporations to provide reasonable compensation to their employees in the form of wages that are subject to payroll taxes. If you receive a significant portion of your compensation from other sources, such as dividends, the IRS may deem these other sources wages and charge you payroll taxes anyway. The IRS considers each case on its own facts, so there is no bright-line rule about how much money you must take as your salary.
Piercing the Corporate Veil
In addition to tax consequences, taking too many bonuses and distributions might hurt your liability protection. Normally, the formal structure of the corporation provides a line between your personal liability and the corporation’s liability. However, when you blur the line between your personal and corporate affairs by taking frequent distributions or using the corporation as your personal source of funds, creditors might be able to convince a court that your corporate structure is a sham. Under such circumstances, the court can "pierce the corporate veil," breaking the protective barrier that shields your personal assets from corporate liability.