Can S-Corporation Earnings Be Contributed to an IRA?

Q: Tax Playa, can a person who did not take any salary but have a little income from an S-corporation make an IRA contribution?
Scott, FL

A: In short, no.  IRA contributions can only be made from "earned income."  An interesting interaction here, though, can be made with the reasonable salary rules of S-corporations...

First, why can't an S-corporation profit dividend taxable to the shareholder be eligibile for an IRA or Roth IRA contribution?  In Publication 590, the IRS defines eligible compensation for IRA contributions to be from the following four sources:

1. Wages, salaries, and tips;
2. Commissions earned;
3. Self-employment income and income from general partnerships in trades;
4. Alimony received

By design, investment income is excluded from the pool available to make IRA contributions.  This is largely to make sure that IRA money has first gone through the Social Security and Medicare tax filter.

S-corporations are interesting.  As has been noted in earlier posts, there is a requirement that more than 2% shareholder-employees pay themselves a "reasonable salary."  If the S-corporation profit, though, is some small number (say, $10,000) it is highly-unlikely that the IRS would find that a reasonable salary (with its resultant FICA tax) needed to be paid.  One of the downsides of not having to pay that reasonable salary, though, is that IRA contributions cannot be made.

Suppose you are in the situation where you don't have eligible compensation for IRA purposes, and spend your time on a modestly-profitable S-corporation?  As I see it, you have three choices:

1. Save for retirement in a taxable brokerage account.  Even here, dividends and capital gains are only taxed at a 15% rate;
2. Pay yourself a reasonable salary equal to the IRA limit.  This is $4000 in 2007 and $5000 in 2008.  If you are over age 50, you get a "catch-up" contribution of $1000.  This usually requires hiring a payroll company and filing quarterly;
3. Get a job at your local coffee place.  At $8 per hour, you only need to work 250 hours in 2007 to get compensation for IRA purposes.

Happy barista-ing!