Article Highlights
- Payroll Taxes
- Corporate Officers
- Employees of a Corporation
- Reasonable Salaries
- Factors
- Flow-Through Deductions
- Wage Limitations
S Corp Does Not Directly Pay Taxes on Income
Unlike a C corporation, which itself pays the tax on its taxable income, an S corporation does not directly pay taxes on its income; instead, its income, losses, deductions, and credits are distributed across its shareholders’ individual tax returns on a pro-rata basis. These distributions are not subject to self-employment (Social Security and Medicare) taxes.
Requirement for Reasonable Compensation
As a result, many S corporations ignore the requirement that each shareholder-employee must take reasonable compensation in the form of W-2 wages in exchange for services performed for the corporation. These wages are subject to Social Security and Medicare taxes (which the corporation and the employee generally split equally); the corporation is also responsible for paying the Federal Unemployment Tax (as well as any state unemployment taxes).
Shareholder, Officer, Employee - Important Distinctions to the IRS
The Internal Revenue Code establishes that an officer of an S corporation is an employee of that corporation for Federal Unemployment Tax purposes. S corporations should not attempt to avoid paying this tax by treating their officers’ compensation as distributions rather than as wages.
Unreasonable Salaries and Social Security, Medicare, and Federal Unemployment Tax
This has been an issue for decades; in 1974, the IRS issued a ruling stating that, when a shareholder-employee fails to take a salary, or if that salary is unreasonable, an auditor should assert that the salary is unreasonable. The officer’s distributions will then be shifted to account for reasonable compensation, and he or she will be assessed the related employment taxes and penalties. At stake here are the employee’s 6.2% Social Security and 1.45% Medicare payroll taxes, the S corporation’s matching amounts, the Federal Unemployment Tax, and whatever state taxes happen to apply.
Who Is an Employee of the Corporation?
Generally, an officer of a corporation is considered an employee of that corporation. The fact that an officer is also a shareholder does not change the requirement that any payments made to that officer must be treated as wages. Courts have consistently held that S corporation shareholders who provide more than minor services to their corporation (and receive payment in return) are employees whose compensation is subject to federal taxes. Tax regulations do provide an exception for officers who do not perform services or who perform only minor services. These officers are not considered employees.
What’s a Reasonable Salary?
The instructions for Form 1120S (“U.S. Income Tax Return for an S Corporation”) state: “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 services rendered to the corporation.” There are no specific guidelines in the tax code regarding the definition of reasonable compensation. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of the individual cases.
Factors that the IRS Considers When Determining a Reasonable Salary
These are some factors that courts have considered when determining reasonable compensation:
- The officer’s training and experience
- The officer’s duties and responsibilities
- The time and effort that the officer devotes to the business
- The corporation’s dividend history
- The corporation’s payments to non-shareholder employees
- The timing and manner of the bonuses paid to key people at the corporation
- The payments that comparable businesses have made for similar services
- The corporation’s compensation agreements
- The formulas that similar corporations have used to determine compensation
The IRS Can Challenge
The problem here, of course, is that it is easy for the IRS to simply list contributing factors that courts have used when determining reasonable compensation and leave it to each corporation to quantify these factors and determine a reasonable salary—all while retaining the ability to challenge the selected amount later if an auditor decides that the compensation is not reasonable.
The IRS has a long history of examining s-corporations’ tax returns to ensure that reasonable compensation is being paid, particularly when a corporation pays no compensation to employee-stockholders.
The Trap of Trying to Maximizing Deductions
Of course, taxpayers cannot pick and choose a particular level of reasonable compensation to minimize their corporate or personal income taxes or maximize their tax deductions; therein lies a trap. Taxpayers instead should consider all the factors related to reasonable compensation. However, pulling all the data together to support such a determination can be difficult and time-consuming. Some commercial firms have the necessary data and resources to properly apply the various factors mentioned in this article so as to determine the proper level of reasonable compensation; this can provide backup in the case of an IRS challenge.
Get Help with Employee Compensation for Your S Corp
If you are a business owner, you can see that determining shareholder compensation can be a tricky matter for s corporations. Please give the experts at Insogna CPA a call if you have questions related to reasonable compensation for S corporation shareholders or how it impacts your specific tax situation.
