One of the most commonly used expressions in articles about taxes is this one: “tax trap for the unwary”. While I would like to be more creative than that, that expression effectively sums up a common situation we’ve seen involving the compensation of shareholder-employees of S corporations. The objective of an S corporation is, of course, to avoid double taxation (once to the shareholder and again to the corporation). So where is the “tax trap for the unwary?’ There are actually two.
The first “tax trap for the unwary” is where the owners of S corporations seek to reduce employment taxes due on amounts paid to them by their companies by characterizing compensation payments as dividends. I”ll leave the discussion to the tax professionals regarding whether the IRS would attempt to recharacterize dividends as salary if the amounts were in fact, paid to the shareholders for services rendered to the corporation.
The second “tax trap for the unwary” is in our neck of the woods; qualified retirement plans. Only W-2 compensation counts as eligible compensation for determining the contribution. No or low W-2 compensation means no contribution or a smaller than the desired contribution can be made.
And then there could be the “cost-of-waiting” penalty. Adopting a 401(k) plan in the latter part of the year may not give the owner enough time to maximize his or her own contributions. Remember 401(k) contributions must be elected in advance and withheld by the employer. A December plan adoption only provides December payroll as a basis for employee deferral.