By Jack Salewski, CPA, CGMA
When is the proper time to make a distribution of earnings and profits to an S Corporation’s shareholders?
“I’ll just take distributions, then pay myself reasonable compensation at the end of the year.” Quack, quack.
“Holding a meeting is a hassle. I’ll just write a check for my distribution when I do payroll.” Waddle, waddle.
Reasonable Compensation is payment for the value of work performed by an S Corp shareholder/owner. Distributions are whatever the Board of Directors deems appropriate (votes on). These are two different events.
If you or your clients are tempted to put off paying Reasonable Compensation to the end of the year or skip an actual meeting to vote on distributions, beware. The IRS believes that if it looks like a duck, walks like a duck and quacks like a duck – it is a duck. And some agents will assess payroll tax penalties and interest for late filing and late payment of the payroll taxes when compensation is not paid throughout the year. There is no reason to take this risk. Here’s what to do instead.
Pay Reasonable Compensation to any shareholders who perform services (shareholder-employees) for the S Corp per IRS Guidelines before making any distribution of earnings and profits. For example, if Reasonable Compensation for the year is $90,000 that equates to $7,500 per month. Once the $7,500 in compensation has been paid then distributions can be made.
The Reasonable Compensation amount needs to be accumulated over time. Let’s say in month one the business pays $7,500 in compensation and since it was a good month there was also a $10,000 distributions paid out. Month two cash flow is tight, so only $5,000 in compensation is paid out. In this case, no distribution can be made.
Now we are in month three. Cash flow has increased dramatically. Before any distributions can be made there needs to be $10,000 paid in Reasonable Compensation. This is made up of $2,500 for month two plus $7,500 for month three. At this point, all Reasonable Compensation has been paid to date, so distributions can be paid in whatever amount the board deems appropriate.
What is “whatever amount the board deems appropriate”? It’s the amount voted on at a board meeting and memorialized in the corporate minutes. This may seem silly if the owner and the board are one and the same. Memorialize it in corporate minutes anyway.
Now you understand why Reasonable Compensation can’t wait until the end of the year, but why not just do distributions at the same time as payroll? Certainly, the business has every right to do distributions as often as the board deems prudent, but there’s no good reason to give the IRS the impression that distributions are compensation in disguise. Said another way, don’t make distributions at the same time as payroll. When distributions are made at the same time as payroll, the Internal Revenue Service will see a duck, no matter how hard you argue that it’s really a puppy. This is especially true if proper due diligence is done retroactively.
The bottom line: Make distributions after Reasonable Compensation has been fully evaluated, documented and paid and after the distribution has been memorialized in the corporate minutes at a time different than that of the payroll preparation.
Pro Tip: All RCReports S Corp Reports include sample meeting minutes.