Roth IRA limits based on earned income

[PeryW]

Last year I put $5000 in my Roth IRA.

TurboTax says i have excess contribution of $1500 - because not enough 'earned income'.

My income came from: a W2 for $3500, and a K-1 for $58,000 from my S-Corp (I do not take a salary).

If I materially participate in my Scorp (everyday, all year), why is that not considered earned income?

Did I check a wrong box somewhere that makes it look like that K-1 was passive income?

[macuser_22]

if your corporation paid you a salary on a W-2 box 1 then it would count as compensation.  Profits on a K-1 is not.   Self-employed income reported  on the 1040 Schedule 1, line 3 minus lines 14 &15 counts.

See IRS Pub 590A "What is compensation" for what counts.

https://www.irs.gov/publications/p590a

[Critter-3 · Accepted solution]

If you work your for your S-corp you MUST take a reasonable salary and issue yourself a W-2 and file quarterly payroll tax returns.  

The IRS position is that an S-Corporation MUST pay a reasonable compensation to an officer before non-wage distributions may be made.  The reason is that they feel that non-wage distributions when no wages are paid is an avoidance of social security taxes.  From the IRS website at http://www.irs.gov/businesses/small/article/0,,id=203100,00.html :

"Reasonable Compensation

S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.

Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation.

Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject to employment taxes."

The page cites Joly vs. Commissioner, 211 F.3d 1269 (6th Cir., 2000) as one judicial finding on the IRS's authority to reclassify distributions to wages subject to employment taxes.  Factors to determine reasonable compensation are given in the ruling.

The AICPA has an interesting article on this topic here: http://www.aicpa.org/publications/taxadviser/2011/august/pages/nitti_aug2011.aspx

You also might want to read a lively discussion on the Tax Almanac website here: http://www.taxalmanac.org/index.php/Discussion_Forum_-_Tax_Questions .  The substance of the discussion seems to be that taking a reasonable salary is not optional and, if you took distributions with no salary, the distributions should be changed to salary with appropriate employment tax returns being filed (late, if necessary.) 

The fastest way to get audited as an S-Corporation is to not report wages to officers on page 1 of the return.

[Opus 17 · Accepted solution]

If you do not participate in the S-corp and are merely an investor, it is not earned income and is not considered compensation for purposes of IRA contributions.  

If you materially participate, you must take a salary that is at least (or more than) fair market rates for the work you perform, that is subject to employment taxes and so on.    You can only take a profit distribution if there are additional profits after paying fair wages to all participants.

[PeryW]

Thank you to all responders - this was exactly the information I needed.