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Reasonable Compensation for S-Corporation Shareholders - Get it Right!

Article Highlights:

  • Payroll Taxes

  • Corporate Officers and Employees of a Corporation

  • Reasonable Compensation

  • Determining Factors

  • Getting it Right

Payroll Taxes 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 flow through to its shareholders’ individual tax returns on a pro rata basis. These distributions are not subject to self-employment (Social Security and Medicare) taxes.

However, if shareholders also work in the business, they are supposed to take reasonable compensation for their services in the form of W-2 wages, and of course, wages are subject to FICA (Social Security and Medicare) and other payroll taxes. This is where some officer-shareholders err by not paying themselves reasonable compensation for the services they provide, some out of unfamiliarity with the requirements and some purposely to avoid payroll taxes.

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 definition of an employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code includes corporate officers. The fact that an officer is also a shareholder does not change the requirement that any payments made to that officer for services provided to the corporation 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, even when shareholders take distributions, dividends, or other forms of compensation instead of wages.

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 Compensation? 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. The following 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 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.

Getting it Right – It is important to ensure that not only is an officer of a corporation compensated in the form of wages for their services, but also that the compensation is reasonable. Quantifying the above factors to determine what compensation is reasonable requires objective consideration of the relevant factors in your circumstances. To complement your objective consideration and the reasonableness of your numbers, you may also want to leverage the comprehensive wage data compiled by the U.S. Bureau of Labor Statistics. And remember to document how you arrived at your numbers.

Please contact this office at 954-362-7113 if you have questions related to reasonable compensation for S corporation shareholders or how it impacts your specific tax situation.   

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