Personal Service Corporations (PSC) - the Sub Chapter S Election and Wages/Employment Taxes

As I have blogged before a Personal Service Corporation can indeed elect Sub Chapter 'S' corporate status and be treated as a disregarded entity for income tax purposes.  This requires the filing of IRS form 1120-S, not IRS form 1120. However if you are successfully (ie profitably) operating a personal service corporation structured as a Sub Chapter 'S' entity you should take some salary and pay employment taxes on that salary particularly if the entity is demonstrating regularity and consistency in generating profits.  Employment taxes are reported quarterly on IRS form 941 AND annually on IRS form 940.  Determining your appropriate salary is critical.  If the salary is too low or non existent, the IRS fines you with payroll tax penalties.  If the salary is too high, you cheat yourself of tax savings. 

Generally speaking the best way I believe to determine salary is to rely on external sources of information such as the Management of an Accounting Practice (MAP) survey conducted by the American Institute of Certified Public Accountants.  This survey shows comparative employment costs for a wide assortment of jobs and serves as a great stepping off point for making a salary determination.  From there you can adjust the salary number based on you own individual circumstances.

Industry compensation surveys etc aside, I've been successful to date demonstrating in audit AND appeal that the shareholder/employee of a Sub Chapter 'S' Personal Service Corporation should only be held accountable for employment tax on wages to the extent that those wages not exceed 1/2 of the entity's profit for the tax year in question.  I'm usually having to defend the taxpayer's previously declared 0% of profitability as employment tax liability and the IRS is usually assessing 100% of profitability as employment tax liability by the time the file gets to my desk. 

So my generic advice is that if you are making money on a regular and consistent basis, declare yourself an employee and pay yourself a wage, file the IRS form 941 and use this expense as a deduction against revenue.  Otherwise you really are running the risk of an employment tax audit. If the IRS tries to declare that 100% of your Personal Service Corporation's (PSC) profit is subject to employment tax simply because the entity is structured as a Sub Chapter 'S' corporation then you should probably retain the services of a professional to represent you in resolving the matter. Representing yourself in these circumstances can be daunting and crushing.

John R. Dundon, EA - 720-234-1177 - jddundon@comcast.net - http://prep.1040.com/jd/ - Enrolled with the United States Department of Treasury to Practice before the IRS - Enrolled Agent # 85353. Under contract with the IRS as a Certified Individual Taxpayer Identification Number (ITIN) Acceptance Agent - I am a Federally Authorized Tax Practitioner (USC 31 Section 330 + IRC 7525a.3.A) regulated under US Treasury Cir. 230.