S corporation shareholders can reap benefits from their ownership stake through profits their companies distribute or retain. Dividend distributions provide owners with an instant return. Profit retention takes longer. Retaining profits increases a corporation’s value and, therefore, its shares’ value. Shareholders realize this value when they sell their shares or when the company is sold. Shareholder-employees can also tap S corporation’s profits by taking a bonus. The way the Internal Revenue Service treats dividends and bonuses depends on the number of shareholders or officers.
In the eyes of the law a corporation is a wholly separate legal entity considered a “person” with perpetual existence and limited liability. It also has the right to conduct business, own assets and incur liabilities. A corporation is created by filing articles of incorporation with the secretary of state. At some point after incorporation an officer or corporate representative must file Form 8553 to elect treatment under subchapter S of the Internal Revenue Code. An S corporation’s income is treated as fully distributed to shareholders who are then taxed on their proportionate share of this income.
Shareholder-employees can proclaim a bonus to take advantage of a rise in an S corporation’s profits. This may be more appealing than salary increases since drastic changes in base wages as an employee-shareholder from year to year could trigger an IRS audit. Profit sharing and performance bonuses generally do not. Alternatively, if an S corporation has sufficient retained earnings and cash on the balance sheet, it can issue dividends. Corporations must comply with corporate administrative requirements and have supporting evidence for an IRS audit. Therefore, the company must declare dividends and document this declaration as board meeting minutes each time dividends are distributed.
Employment Taxes – Compensation
The courts repeatedly uphold the IRS’ position that payments to officers are subject to federal employment taxes whether the person is an officer or an officer and shareholder. In addition, the IRS states that “the S corporation must determine and report an appropriate and reasonable salary for that shareholder.” When a corporation pays its officers or employee-shareholders salaries, wages or bonuses, even if paid via as an independent contractor via a 1099, these wages are subject to federal employment taxes.
Employment Taxes – Dividends
If payments to employee-shareholders are reasonable, dividends distributed to shareholders are not subject to employment taxes. If, however, an S corporation does not pay reasonable compensation or pays no compensation at all, the IRS will treat the dividends distributed to employee-shareholders as compensation. These dividends will then be subject to employment taxes.