Spouses 50-50 owners of S-Corp but Only One Materially Participates

[SusanMC]

My spouse and I own an LLC that files taxes as an S-Corp in Florida. We are 50-50 owners, but I am the only one who materially participates in the business and I pay myself a reasonable salary.  When I pay distributions, will I need to pay them 50% to each of us separately?  And will that be a problem since my spouse isn't receiving a salary but is receiving distributions?  Would it be possible to just pay myself the distributions?

[DavidD66]

You cannot just make distributions to yourself.  Distributions from an S-Corp (or LLC taxed as an S-Corp) must be made in proportion to their ownership.  If your spouse does not materially participate in the business, you don't have to pay him/her a salary; however, it leaves you open to scrutiny by the IRS to determine if those distributions should be characterized as salary, either in whole or in part.

[Mike9241]

if you don't pay distributions proportionally, then the IRS will say the S-Corp had 2 classes of stock that is forbidden for S-Corps.  It would then treat your S-Corp as a C-Corp. the S-corp election is revoked and you can not re-elect for 5 years.  if it had income it will owe taxes. penalties and interest, In addition, instead of the distributions being treated as a return of capital, they will be taxable dividends.  

since distributions show up on the k-1 and the IRS will see that 50/50 owners did not get the same distributions, they might start an audit. you need to confer with a tax pro before you file that S-Corp return. even if you already filed it, consult a tax pro. 

[SusanMC]

Thanks for the replies.  As a follow up, you mention that by paying my spouse only the 50% distribution share and no salary (because no material participation) I might be scrutinized by the IRS and be asked to characterize part of the distribution as salary, but since the spouse is not an employee I want to avoid that.  I'm wondering if it would be easier to change the ownership of the LLC (taxed as S-Corp) and just make myself 99% owner.  If my spouse was 1% owner, would the IRS be questioning why there was no salary?  The only reason we set it up as a multi-member LLC in the first place was for perceived better legal protection in Florida.

[ZoltanB45]

You do not have to make him a 1% owner. If the total shareholder salary is 40% of the profit of the business,  that will be enough to avoid any scrutiny. For example, if the net profit prior to officer salary is $100,000, pay yourself $40,000 and you will be fine.