This article relates to Employee-Owners of a “S” corporation.
One can be an owner or partner in a “S” corporation, but not an employee (performing services for the same entity). But if you are an owner and employee there are special tax laws that effect you. If you’re taking cash out, you could be creating serious tax issues.
As an Employee-Owner, you can withdraw funds, but only after paying yourself a salary that meets the IRS’s definition of “reasonable compensation.” Many small business owners mistakenly classify these withdrawals as dividends, draws, or loans without meeting the legal requirements. According to IRS regulations, any distribution to an Employee-Owner must be treated as salary and reported on payroll tax returns. If not, the IRS can reclassify these payments as wages, leading to back taxes and penalties. Courts have consistently supported the IRS’s authority to reallocate income to reflect fair compensation. While the tax code doesn’t define “reasonable compensation” precisely, courts consider factors like industry standards and replacement costs for the owner’s role.
Distributions beyond reasonable compensation may qualify as dividends under Section 1368, but misclassification can trigger audits and financial penalties.
Loans to or from the corporation must be formalized with proper documentation, including terms, interest, and board approval, to avoid being treated as disguised compensation. Health insurance premiums paid by the corporation are considered salary but may be deductible under certain conditions. Paying personal expenses through the business is especially risky—it can lead to the IRS “piercing the corporate veil,” eliminating liability protection. Even if your company is losing money, you’re still required to pay yourself a reasonable salary if distributions are made. To stay compliant, always document loans properly, avoid using corporate funds for personal expenses, and ensure your compensation aligns with IRS expectations.