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S corporation payments: Salary or distributions?

March 19, 2014

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Many dealerships elect to be S corporations because these legal structures offer the best of both worlds. Like C corporations, S corporations limit the dealer-owners’ liability. But S corporation dealership income flows through to the owners’ personal tax returns, as in a partnership. So, S corporations allow owners to escape the double federal taxation that burdens C corporations.

Why it matters

Flow-through tax treatment means dividend distributions from S corporations typically aren’t taxable to the shareholder. (State tax treatment varies.) And they’re not subject to payroll taxes, either.

In 2014, federal payroll taxes include Social Security of 12.4% on the first $117,000 in wages and Medicare tax of 2.9% on all wages, without any limit. And, under the Affordable Care Act, an additional Medicare tax of 0.9% is owed on wages above $200,000 for singles and heads of households and $250,000 for joint filers.

So, dealer-owners may be tempted to maximize their distributions, and minimize their salaries. But the IRS requires S corporation owner-employees to take a “reasonable” salary.

What to consider

When deciding how much to allocate to owners compensation, evaluate what an unrelated third party would pay the owners for their contributions to the business. Factors to consider include:

  • Daily responsibilities and average weekly hours worked,
  • Education level and other training,
  • Years of franchise experience and previous salary history,
  • Personal attributes, including strategic vision, energy and mentoring abilities, and
  • Personal guarantees on floor plans and other loans.

Also look at external factors that affect compensation, such as your dealership’s market share and financial condition and prevailing compensation rates for other dealer-owners in your geographic location.

What else the IRS considers

The IRS’s New Vehicle Dealership Audit Technique Guide instructs auditors to consider bonuses and perks, including travel and entertainment expenses, when determining whether owners compensation is reasonable.

The IRS also uses an independent investor standard to indirectly determine what’s reasonable. This backdoor approach estimates how a hypothetical third-party buyer would compensate an employee if the business were sold. As long as the hypothetical investors would receive a reasonable return on their investments, the IRS generally presumes owners compensation is reasonable.

To minimize IRS scrutiny, base bonuses on a predetermined formula that’s applied consistently to all highly compensated managers and documented in your corporate minutes.

What you risk

If the IRS reclassifies your distributions as compensation, additional payroll taxes plus penalties and interest will be owed. So it’s important to ensure dealer-owner salaries aren’t unreasonably low.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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