Owners of small businesses and sub chapter S-Corporations have often allowed profits to flow to the shareholders as distributions taxable at ordinary rates. The IRS is currently focusing on tax collection from small corporations. The IRS however, is attempting to reclassify excessive profits as salaries subject to payroll taxes and thus subjecting the owner/shareholder to perhaps thousands of dollars of extra taxes, penalties, and interest.
Small corporation owners and the IRS have recently started a tug of war with business owners looking for ways to minimize taxes, and the IRS looking to maximize its collection effort. The IRS has assembled certain areas they believe make the small business owner vulnerable.
The basis of this tactic by the IRS is claiming the owner/shareholder understated their salary based on their labor. This tactic is sometimes difficult to prove. Owners of C-Corporations also run the risk of double taxation when the IRS deems their salary or 1099 payments as not deductible. Since officers/owners of a corporation are statutory employees of their corporation, failure to treat compensation as wages, subject to payroll taxes, can cause the 1099 income they pay to themselves to be reclassified as a dividend. The IRS sometimes takes the same tact if they feel too much salary has been taken by the owner/shareholder.
In both cases illustrated above, the IRS reclassification of compensation to dividends creates double taxation whereby the compensation is not deductible and the money taken by the shareholder/officer is taxable on a personal level as a dividend without the benefit of a deduction on the corporate level. This being said, the same income is taxed at both the personal and corporate level.*
*Dividends are not deductible except for regulated investment loss, real estate investment trusts, personal holding companies, and accumulated earnings tax.