It works fine and is very common for small businesses in the UK. I guess this goes to show how contextual accounting advice can be.
On that note, I'll add that I'm ever so glad that in all my interactions with them HMRC have been polite, friendly, supportive, helpful and nothing like the abusive business murderers that the IRS appear to aim to be - even when I fucked something up that was obviously my fault. I don't understand why the IRS feels that they need to be such assholes about everything. They should see their job as what it is: an essential part of the infrastructure that supports the economy and, indirectly, supports businesses. Their role should be to make business easier, not harder.
I say this as someone who once had a pretty decent unexpected 5-figure liability that I had to work out with them.
I also don't feel like zealous enforcement of unremitted payroll tax is particularly abusive, since that's essentially describing companies stealing from their employees.
I had a run in with the labor department at my first company. I wouldn't exactly call them jerks (or nice) but I was able to get them to cut in half a 5 figure amount they assessed me (a lawsuit was filed) by having a personal meeting with the local office head. Without an attorney. After I cut the deal I then said "oh one more thing can I have 5 years to pay this back?". And he agreed (I didn't need the 5 years, it wasn't a large amount, but I thought why not?)
From what you describe, they sound much like HMRC.
And yes, withholding payroll tax (or VAT) and not passing it on to the government is pretty crappy. HMRC is typically understanding if this is a few months or even a year down the line and they think the business will be able to pay up - they frequently agree payment plans for such things - but three years without noticing kinda takes the piss.
However the US government wants you to also pay Social Security and Medicare tax, which you only pay on employment income. Therefore they force you to take a "reasonable"[1] salary from the company. Everything else left in the company's account at the end of the year is your non-employment income.
It avoids double taxation. It doesn't put you in a lower tax bracket.
1. Reasonable is determined by them.
For people in our industry, it's hard to see a definition of "reasonable" that would be financially beneficial. You start a tech company. You pull $100k out every year, putting you right smack in the middle of the income distribution for experienced tech people. But because of a loophole, you get to reclassify $50k of that $100k as a distribution, and not pay FICA on it. To support that (sorry) scam, you claim $50k is your "reasonable" salary --- putting you way on the low side of the industry. How convenient.
People obviously do it and get away with it. I'm glad it's an audit flag.
I operate as an s-corp and pay myself a reasonable salary, matching that of the salary I could get in the current job market in the area I live in. Anything I clear above this is only taxed with my regular taxes.
If I was running a C-Corp instead of an S-Corp, I'd get my $100k salary, and any extra would have been taxed at the 30% corporate rate when it was taken in, then the 20% capital gains when it's distributed to me as profit.
I don't know. What salary would you take for your honest-to-god dream job?
Many people will take a pay cut for their dream job, but very few are willing to be exploited in the process.
If a company owner is taking a very low salary in order to maximise company profit (and minimise tax) then they (as an employer) are exploiting themselves (as an employee) to do so.