The tax code allows for corporations to make an “S election”. By electing to be treated as an S corporation, the business is nominally a traditional corporation for legal purposes (with all the usual requirements to establish and maintain a corporation), but is taxed as a pass-through entity (similar to a partnership). This allows businesses to enjoy many of the transferability, limited liability, and other benefits of a corporation, but still get the pass-through treatment that avoids two tiers of taxation.
When it comes to owners in particular, a key distinction is that with a partnership, any/all income allocable to an active partner in the business is automatically and fully treated as self-employment income, subject to FICA self-employment taxes (Social Security and Medicare employment taxes).
However, with an S corporation, the corporate roots – where payments to owners can occur either as salary compensation for employment, or as a dividend to ownership – are at least partially maintained.
Of course, it doesn’t make sense to pay a traditional “taxable” dividend from an S corporation, because the whole point is that it’s a pass-through entity, where the income of the S corporation is automatically and already taxed to the owners when the business earns it. As a result, taking money out of an S corporation is simply classified as a “distribution” – functionally it’s a dividend, but a nontaxable one because the taxes were already paid when the income was earned by the business to begin with. This ensures that an S corporation is only subject to a single tier of taxation.
Similarly, when an owner-employee of an S corporation receives a salary payment (i.e., for services rendered to the business), the payment is deductible to the business, and taxable to the owner-employee. The net result is substantively the same as an S corporation dividend – the income is only taxed once, to the owner-employee.
While both the pass-through income of an S corporation, and a salary payment from an S corporation, are ultimately taxable to the owner-employee, at ordinary income rates, their treatment is not identical. Because as “corporate” income, an S corporation’s pass-through income by default is not subject to employment taxes under Revenue Ruling 59-221, since it was not directly earned (even though it’s otherwise treated as ordinary income). By contrast, a salary payment is fully subject to FICA taxes.
In other words, S corporation owners actually have control over whether they will receive their business income as salary, or as a dividend distribution (of previously-taxed pass-through income), where only one is subject to FICA taxes but not the other
The fact that wages from an S corporation are subject to FICA taxes, but dividend distributions are not, can be a non-trivial impact. FICA taxes include a 12.4% Social Security tax up to the Social Security wage base (which will be $127,200 in 2017), plus another 2.9% of Medicare taxes (for an unlimited amount of income). In addition, there’s another 0.9% Medicare surtax on earned income above $200,000 for individuals (or $250,000 for married couples). In total, this leads to FICA tax rates of 15.3% initially, dropping to 2.9% beyond the Social Security wage base, and rising to 3.8% at higher levels of earned income.In the logical extreme, then, an S corporation owner should want to pay nothing out as salary, and everything out as a dividend distribution. Since any/every dollar would save a minimum of 2.9%, and as much as 15.3%!
Recognizing this, though, the IRS still prevents a shareholder-employee from completely avoiding employment taxes, by requiring S corporation owners to be paid at least “reasonable compensation” for their actual services rendered to the business. In fact, for more than 40 years now – since Revenue Ruling 74-44 – the IRS has been imputing implied wages to owner-employees who fail to pay themselves reasonable compensation (i.e., recharacterizing their dividend distributions as wages, and applying FICA taxes accordingly).
In other words, if the S corporation earns $400,000 of profits, but the owner-employee did work that would have cost $100,000 for another employee to be hired to do it instead, then the owner-employee must report at least the $100,000 of “reasonable” compensation that would have been paid for that position (and only take the remaining $300,000 as a dividend distribution).
Notably, the exact determination of what constitutes a “reasonable” compensation is ultimately based on the facts and circumstances of the individual owner-employee. IRS Fact Sheet FS-2008-25 notes that relevant factors include the person’s training and experience, duties and responsibilities, time and effort devoted to the business, compensation to other (non-shareholder) employees, what comparable businesses pay for similar services, and more. Or stated more simply, as the name implies, the owner-employee doesn’t have to be paid the ‘maximum’ possible, nor any minimum specified amount; instead, the compensation must simply be “reasonable” for the services rendered. But clearly $0 of salary (and 100% of S corporation dividend distributions) is not reasonable compensation for an active owner-employee involved in the business!
Notwithstanding the fact that the tax code requires an S corporation to pay “reasonable compensation” to an owner-employee, in many (or even “most”) cases, an S corporation would still not have to pay all of its profits out as wages subject to employment taxes.
Classifying 100% of S corporation profits as salary might be necessary for a sole owner S corporation with few or no employees, since in that context virtually every dollar of profits really is attributable to the active employment efforts of that owner/employee. But in “larger” businesses with multiple owners and/or employees who all contribute to the value of the business, at some point of the profits of the business are not just a function of the owner/employee, but also of the value of the business itself. That could be value created from the services of non-shareholder employees, or from the capital/equipment of the business – both of which the IRS recognizes as being part of the profits of the business, and separate from reasonable compensation of the owner-employee themselves. Or viewed another way, the whole point of differentiating dividend distributions from salary or other wages is that the latter is a reward for working in the business (and subject to FICA taxes), while the former is the financial reward for creating a profitable business in the first place (and not subject to employment taxes).
In practice, this means that owner/employees will often “split” their total share of the profits between taxable salary wages (subject to FICA taxes), and S corporation dividends that are exempt from FICA taxes.