By Lee R. Phillips

The Unemployment Compensation Extension Act of 2010 was designed to follow the “pay as you go laws,” which means, the bill needed to generate taxes equal to the cost of extending unemployment payments.

What does all this have to do with S corporations?  The plan was to make the small businessman pay for the unemployment bill by increasing taxes on “distributions.”

There are two ways a small businessman can get money out of an S corporation.

1. Salary
2. Distributions (Dividends)

Of course, the salary is subject to the social security and other “social taxes.”  Distributions, on the other hand, were not subject to the social taxes, i.e., payroll taxes.

The S corporation owner must take a “reasonable” salary out of the company, but the rest of the profit can come out as distribution, which saves the payroll taxes.  That’s potentially a 15% + savings on the distributions over the wages.

The final version of the Unemployment Compensation Extension Act of 2010 passed both the House and the Senate with a provision that forces the recipient to pay self employment taxes (payroll taxes) on all distributions made from an S corporation.

The Unemployment Compensation Extension Act of 2010 was a 50,000 plus word bill when it left the Senate for the President’s desk.  Mysteriously, the bill that the President actually signed was a mere 1,298 word bill.

The provision attacking Subchapter S corporations was part of the bill that disappeared.  Obviously, the bill went from a pay-as-you-go bill to an increase-the-deficit bill.  But, the major tax benefit enjoyed by S corporation owners is safe for the time being.

HOWEVER, it is openly stated that IRS has put the “reasonable salary” issue on the top of their list of audit subjects.  You had better pay yourself a reasonable salary.

The IRS lists the criteria that the auditor is supposed to use in order to determine what a reasonable salary is.  The following factors are to be considered.

No one factor is controlling.  They all go to the weight of the evidence in order to determine what a “reasonable wage” is.

1. The employee’s duties
2. The experience and background of the employee
3. The unique knowledge the employee has of the business
4. How big the business is
5. How much the employee contributes to the businesses’ profitability
6. How much time the employee spends at the business
7. The general economic conditions in the locality of the business
8. The amount of responsibility given to the employee
9. Seasonal adjustments in salary
10. How much stock the employee has in the business corporation
11. What other businesses of similar size, location, and nature pay

If the IRS is gunning for company owners who pay themselves distributions, you had better make sure you consider the above list in determining what is reasonable for your wage before you start paying distributions out of your S corporation.