Contents
- Why salary vs distributions exists (and why it’s policed)
- Wages vs distributions: what they are (and aren’t)
- Statutory foundation: corporate officer = employee
- Landmark cases: “zero salary” and “too low salary”
- How to determine reasonable compensation (3 methods)
- Why 60/40 and 50/50 rules are dangerous
- What happens when the IRS recharacterizes distributions
- Washington wrinkle: LLC S corp vs Inc. for PFML/WA Cares
- Best practices: defensive compliance that holds up
1) Why salary vs distributions exists (and why it’s policed)
In a sole proprietorship, all net earnings are generally subject to self-employment tax. In an S corp, wages are subject to FICA, but distributions typically are not—creating a legitimate planning lever. The IRS polices this because the tax savings come directly from reducing payroll taxes that fund Social Security and Medicare. :contentReference[oaicite:2]{index=2}
2) Wages vs distributions: what they are (and aren’t)
W-2 wages are deductible to the S corp and reduce pass-through income; they also trigger withholding and payroll taxes. Distributions are balance-sheet equity withdrawals; they are typically tax-neutral when paid because owners already pay tax on S corp profits via the K-1—regardless of cash actually distributed (“phantom income”). The key compliance rule: distributions generally shouldn’t replace wages when the owner is performing services. :contentReference[oaicite:3]{index=3}
3) Statutory foundation: corporate officer = employee
The doctrine’s “hook” is that corporate officers are statutory employees for FICA purposes unless they perform no (or only minor) services and receive no remuneration. For most owner-operators, that exception is inapplicable. Revenue Ruling 74-44 is the classic recharacterization pattern: amounts labeled as “dividends” (or distributions) are treated as wages when they are really pay for services. :contentReference[oaicite:4]{index=4}
4) Landmark cases: “zero salary” and “too low salary”
Veterinary Surgical Consultants (2001)
Sole service provider took zero wages and all distributions. Court treated distributions as wages because he was the revenue engine and an officer-employee. :contentReference[oaicite:5]{index=5}
Watson (8th Cir. 2012)
The modern template: not zero wages—but “unreasonably low” wages. Court accepted market-data-based reallocation of distributions into wages. :contentReference[oaicite:6]{index=6}
The pattern across cases
Courts look through labels. If the owner’s labor drives revenue and wages are suppressed, the wage/distribution split gets rewritten to what the court believes is reasonable. :contentReference[oaicite:7]{index=7}
5) How to determine reasonable compensation (3 defensible methods)
A) Cost approach (“many hats”)
Break the owner’s work into roles (sales, ops, admin, technical delivery), assign market wages per role, multiply by time spent, and sum. This often produces a defensible wage that fits small business reality better than benchmarking a generic “CEO.” :contentReference[oaicite:8]{index=8}
B) Market approach (benchmarking)
Use external wage data (industry, geography, company size) and document the comparable role. The strength is simplicity; the weakness is choosing a truly comparable data set. :contentReference[oaicite:9]{index=9}
C) Income approach (independent investor test)
Frame compensation around what a hypothetical investor would require as a return on equity. If the “investor” still earns a strong return after paying the owner’s wage, it supports the position that remaining profit is a return on capital (distribution), not labor. :contentReference[oaicite:10]{index=10}
6) Why “60/40” and “50/50” rules are dangerous
Fixed percentage splits have no legal safe harbor and ignore the economics of the business. A 50/50 rule can be absurdly low at small income levels (audit bait) and absurdly high at large income levels (unnecessary payroll tax). Auditors often treat rigid percentages as a sign the taxpayer did not do a real analysis. :contentReference[oaicite:11]{index=11}
7) What happens when the IRS recharacterizes distributions
Reclassification triggers back payroll tax (employee + employer FICA), and can stack failure-to-deposit, failure-to-file payroll return penalties, accuracy-related penalties, plus interest. The “nuclear” risk is the Trust Fund Recovery Penalty (TFRP): the IRS can assess the withheld portion against responsible persons personally if payroll taxes weren’t paid. :contentReference[oaicite:12]{index=12}
Risk-reward reality
The report models how the total cost of “losing” can exceed the original payroll tax savings once penalties, interest, and professional fees are included. :contentReference[oaicite:13]{index=13}
8) Washington wrinkle: S corp is a tax status, not an entity type
Washington can treat owner wages differently depending on whether the S corp is legally formed as an Inc. (corporate officer) versus an LLC that elected S status (LLC member). The report highlights conflicts for state programs like PFML and WA Cares, where an LLC member may be treated as self-employed at the state level even while federally they must run payroll and pay FICA as an employee. :contentReference[oaicite:14]{index=14}
Best practices: defensive compliance that holds up
- • Do an annual reasonable comp study (cost/market/investor test) and save the workpapers.
- • Pay wages on a regular cadence (not a year-end “true-up” only).
- • Put the wage decision in annual minutes: duties reviewed, comps considered, salary approved.
- • Avoid shareholder “loans” and personal expenses (they compound risk across multiple audit issues).
- • Don’t rely on percentage rules; document role, hours, and market comparables.
- • For WA: confirm whether you’re an LLC S election or an Inc., and configure payroll taxes accordingly.
The report’s theme: the goal isn’t to “win an argument,” it’s to build a file that makes the argument unnecessary. :contentReference[oaicite:15]{index=15}