Magazine article The CPA Journal

Federal vs. States Reasonable Compensation Tug-of-War

Magazine article The CPA Journal

Federal vs. States Reasonable Compensation Tug-of-War

Article excerpt

RRA '93 lifted the cap on the medicare portion of social security taxes, effective for wages paid on or after January 1, 1994. Accordingly, the stage has now been set for a conflict between Federal and state taxing authorities regarding the appropriate level of wages vs. profit distribution to be paid to S corporation principal shareholders.

On one hand, the Federal government prefers that an appropriate portion of shareholder distributions be paid in the form of salary so that it gets its share of payroll taxes. From a Federal income tax standpoint, there is generally no issue (assuming the shareholder is not deemed to be a passive activity participant), as the shareholder reports in total the same amount of income, whether it be in the form of wages or Schedule E flowthrough.

States such as New York and New Jersey, which impose a corporate level tax on S corporation net income, on the other hand prefer that S corporation profit be distributed not in the form of salary, but as a distribution out of AAA. A payout via salary will lower the amount of corporate net income, and, accordingly, the corporate income tax collectible by the state tax authority. In contrast to the Federal government, payroll taxes play a minimal role on the state level, with there typically being only SUTA imposed on the first $7,000 to $17,000 of income. …

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