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Monday, March 13, 2006

DIVIDENDS VS. SALARIES IN 'S' CORPORATIONS

It is fairly well known to practitioners that it is generally advantageous for a stockholder of a Subchapter S corporation to receive funds from the company as a distribution/dividend on his stock, rather than as compensation. This is because compensation payments are subject to employment taxes, while distributions/dividends on stock are not.

This tax advantage is equally known to the IRS. In situations where the IRS believes a stockholder provided services to the corporation but did not receive reasonable compensation, the IRS will seek to characterize some or all of the dividend distributions as compensation and thus subject the payments to employment taxes. This is particularly likely in the situation where there is only one stockholder, or when all stockholders provide services and do not receive enough compensation.

Consequently, it is advisable that shareholder/employees receive some of their cash flow from the 'S' corporation as compensation. 'S' corporations that characterize all of their payments to shareholder/employees as dividend distributions are especially vulnerable to IRS attack on this issue.

In a recent article in Practical Tax Strategies, James L. Wittenbach and Ken Milani, professors of accountancy at the University of Notre Dame's Mendoza College of Business in Notre Dame, Indiana, offer the following additional suggestions to minimize an IRS attack on this issue:

A. Develop a salary or wage policy (e.g., per month or per hour) and compensate the shareholder/employee in accordance with the policy.
B. Consider the following nonexhaustive list of factors when setting compensation in order to maintain reasonable levels of compensation:
1. The qualifications of the employee qualifications.
2. The nature, extent, and scope of work performed by the employee.
3. The nature and size of the business.
4. The financial results of the business as impacted by the employee.
5. The compensation that is paid for similar work in comparable companies and businesses.

By documenting the above issues in corporate minutes, the company will go a long way in building a solid defense that its characterization of some payments to shareholder/employees are dividends and not compensation.
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