Self-Employment for the Shareholders

A basic principle of taxation is that anyone who earns income should pay tax on it. “The existence of a validly organized and operated corporation does not preclude taxation of income to the service provider instead of the corporation.”

A taxpayer and his wife, who is a realtor, each owned S corporations. The taxpayer ran his construction business through one corporation while his wife runs her business through another corporation. The S corporations recognized the income and operating expenses of their businesses. Neither the taxpayer nor his wife received a salary from the S corporations. No payroll taxes were paid on moneys distributed to them. They did report income flowing through (pass-through income) to themselves from the corporations and paid income tax on the amounts, but no FICA or self-employment tax.

In this case, the IRS and the Tax Court has determined:
· The person providing the service is an employee of a corporation that has the right to instruct or control the employee in some meaningful sense.
· There exists a contract or similar arrangement between the corporation and the service provider that recognizes the right to instruct or control.

Both of these factors were absent in this case. Therefore, it has been upheld by the Tax Court to subject the taxpayers’ income from their S corporations to self-employment tax.

If you have an S corporation where the shareholder(s) are performing services for the S corporation, they should be drawing a reasonable salary and reporting it on IRS Form W-2.

Further reading:

Corporations

S Corporations

Tax Information for Corporations

Publication 542