“Amounts Distributed from S-Corporation can be “Return of Capital” Rather than Salary” by Les Smeach, CPA/ABV, CVA, CFF | Principal – Tax

In a recent case the IRS attacked the unreasonably low salary paid to a shareholder from the S Corporation. Based on empirical evidence and professional judgment the expert for the IRS determined that out of total distributions paid to the shareholder from the S Corporation of $227,651 and $199,470 in 2002 and 2003, $91,000 was considered salary each year.

What is interesting is the IRS was successful in increasing the amount subject to employment taxes however; they also suggested a reasonable way to support the “return of capital” argument on the balance of distributions which were not subject to employment taxes.

As a result, S-Corporations that want to continue to use this strategy need to support the determination of reasonable compensation amounts using empirical compensation surveys and studies. What they will get in return is successful treatment of “return of capital” for excess distributions. In today’s tax environment that could mean more than $ 5,000 in extra cash flow, based on the numbers above.