S corporation owners often take modest salaries as a tax-saving strategy. By distributing most of the corporation’s profits in the form of dividends rather than wages, the company and its owners can avoid payroll taxes on these amounts. The tax savings may be even greater now that the additional 0.9% Medicare tax on wages in excess of $200,000 ($250,000 for joint filers and $125,000 for married filing separately) has gone into effect. (S corporation dividends paid to shareholder-employees generally won’t be subject to the new 3.8% Medicare tax on net investment income.)
Although S corporations may be tempted to pay little or no salary to their shareholder-employees, this is a dangerous tactic. The IRS has targeted S corporations, assessing unpaid payroll taxes, penalties and interest against companies whose owners’ salaries are unreasonably low.
To avoid an unexpected tax bill, S corporations should conduct an analysis — using compensation surveys, company financial data and other evidence — to establish and document reasonable salaries for each position.