Running an S Corporation comes with its unique set of challenges, one of which is ensuring that
shareholder-employees receive reasonable compensation. But what happens if your S Corp cannot
afford to pay this reasonable compensation? This situation can be tricky, but understanding the IRS
guidelines and potential solutions can help you navigate it effectively.
Understanding the IRS Requirements
The IRS mandates that S Corporations pay reasonable compensation to shareholder-employees for the
services they provide before making any non-wage distributions. This is to ensure that payroll taxes are
appropriately paid on wages. However, there are instances where an S Corp might struggle to meet this
requirement due to financial constraints.
What to Do If You Cannot Afford Reasonable Compensation
- Prioritize Wages Over Distributions: The IRS is more concerned about ensuring that
wages are paid before any distributions. If your S Corp cannot afford to pay reasonable
compensation, it should not make any distributions to shareholder-employees. This
means that if you can’t pay yourself a reasonable salary, you should also refrain from
taking any distributions. - Document Financial Hardships: Keep detailed records of your company’s financial
situation. Documenting your financial hardships can be crucial if the IRS questions your
compensation practices. This includes maintaining records of income, expenses, and any
extraordinary circumstances that have impacted your ability to pay reasonable
compensation. - Adjust Compensation in Future Years: If your S Corp experiences a temporary financial
setback, you might be able to adjust compensation in future years. This means that once
your financial situation improves, you can increase your compensation to make up for
the shortfall in previous years. - Consult a Tax Professional: Navigating IRS regulations can be complex, especially when
dealing with reasonable compensation issues. Consulting with a tax professional can
provide you with tailored advice and help you develop a strategy that complies with IRS
guidelines while addressing your financial constraints.
Consequences of Not Paying Reasonable Compensation - Failure to pay reasonable compensation can lead to tax consequences:
- IRS Reclassification: The IRS may reclassify non-wage distributions as wages, subjecting
them to employment taxes. This can result in significant back taxes, interest, and
penalties. - Increased Scrutiny: Consistently failing to pay reasonable compensation can increase
the likelihood of an IRS audit. This can be time-consuming and costly for your business. - Legal and Financial Penalties: In addition to back taxes and interest, the IRS can impose
fines for underpayment of payroll taxes. In severe cases, your S Corp status could be
revoked.
Conclusion
While the inability to pay reasonable compensation to a shareholder-employee poses significant
challenges, it’s not an insurmountable problem. By understanding the potential consequences and
exploring viable strategies, an S Corporation can navigate this difficult situation while minimizing risk.
Prioritizing open communication, careful planning, and proactive management will help ensure that the company remains compliant with IRS requirements, even during tough financial times. Remember, staying informed and seeking professional advice when needed are key to maintaining the financial health and legal standing of your S Corporation.