Does The IRS Think Full-Time S-Corp Shareholders Are Also Employees?

After asking about the taxation of fringe benefits for shareholders in an S Corp, it occurred to me that there could be two types of shareholders. Those who are silently collecting whatever profits come in from one year to the next and those who are actively working at the company.

Are these two roles seen as separate by the IRS, meaning that one person could collect non-taxable benefits as an employee even when those benefits would be considered taxable income to shareholders?

Yes, the IRS does consider those two to be different roles, and each has their own set of tax rules. If you receive income without being actively involved in the business, that income is usually categorized as passive income. Basically, the IRS treats such a shareholder as an investor, and not as a contributing member of the company (I.e. Does not have any influence in the direction of the company).

Passive income cannot be combined with your regular income - meaning you can't use one to offset the other.

If an employee is also a 2% or more shareholder in an S-Corp, then he or she is classified as such for purposes of taxation of fringe benefits regardless of whether the relationship involves any work in the corporation.

A strategy worth considering is to elect out of S status, run the corporation as a C corporation and then, at the end of the year, pay some or all of the profits out as compensation. It can be a sort of roll your own S Corporation. You get the advantage of being able to ignore the S Corp ownership rules for benefits and if the business actually does need to accumulate some money for a specific purpose, you can do so at possibly lower tax cost then if you have to pay tax on all the net income on your own return.