The issue of what reasonable compensation for shareholder-employees of S corporations should be has been around for some time. Every time the IRS accepts a Form 2553, “Election by a Small Business Corporation,” it sends a CP261, “Notice of Acceptance as an S corporation.” This acceptance letter specifically emphasizes the requirement for shareholder-employees to be paid reasonable compensation for the services that they provide to the corporation. The IRS has increased its interest in this area over the past few years, and it is now more likely than ever that the adequacy of a share holder employee’s salary could become the subject of an IRS audit.
Why Reasonable Compensation Is an Issue?
One of the advantages of the S corporation business model is the absence of the double taxation inherent in the C corporation model. S corporations are flow-through entities whose ordinary business income is taxable income to the corporation’s shareholders. Ordinary business income is passed through to shareholders in proportion to their ownership interests via reporting on Schedule K-1. The S corporation is therefore not taxed at the entity level, and the ordinary business income is taxable for federal purposes to individual shareholders on their Form 1040. The ordinary business income passed through to owners is not subject to FICA (Federal Insurance Contributions Act) or FUTA (Federal Unemployment Tax Act) taxes, and it is not subject to self-employment tax (Revenue Ruling 59-221, 1959-1 C.B. 22). These employment taxes comprise Medicare, Social Security, and unemployment taxes. Partnerships and LLCs electing to be treated as partnerships are also flow-through entities, but all ordinary business income is subject to FICA taxes. It is this difference in the treatment of employment taxes that can cause issues for taxpayers and where CPAs can provide valuable assistance. Salary payments are subject to employment taxes via the employee withholding and employer matching requirements. Shareholders who also work for their own S corporation can save a significant amount of employment taxes if they choose to pay themselves little or no salary.
Exhibit 1 shows a simple Excel spreadsheet that can be used to analyze the difference between total tax liability for a shareholder-employee of an S corporation at different salary levels. The table shows that the lower the shareholder’s salary, the less the total tax liability. The taxes on paying a salary of $60,000 compared to no salary are $27,679 − $19,479 = $8,200—a significant savings. Not paying any salary would be an automatic red flag to the IRS, however. A shareholder-employee might set a desired salary at $60,000, but if a reasonable salary is actually $30,000, this would require paying $3,974 ($27,679 − $23,705) more in taxes than is necessary.
The IRS wants to prevent this potential loss of tax revenue due to the manipulation of employment taxes, and tax advisors can help clients avoid the potential overpayment of salary and the resulting extra taxes. In order to address this issue, the first step is to establish who is an employee of the corporation.
Who Is an Employee?
As mentioned earlier, a shareholder-employee who provides services to a corporation is expected to be paid reasonable compensation and is therefore an employee. An individual hired in the ordinary course of business—not a shareholder or an officer, who is compensated as such— is obviously an employee. In addition, a 2008 IRS fact sheet specifically includes corporate officers within the definition of “employee” for FICA, FUTA, and federal income tax withholding purposes. Unless the corporate officers provide only minor or no services, any compensation they receive or are entitled to receive is subject to federal employment taxes. This is noted in the IRS’s instructions for Form 1120S, line 7, which cautions: “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.” The tax law thus requires a reasonable salary to be paid to shareholder-employees and officer-employees. If this is not done, the IRS can recharacterize dividends paid in lieu of reasonable compensation as salary under Revenue Ruling 74-44. In addition to classifying payments as dividends, a corporation may classify payments as loans to shareholders or as distributions other than dividends. Regardless of the recorded form of the payment, if reasonable compensation has not otherwise been made, such payments can be reclassified as compensation. This position has been supported by several court cases:
■ Joly v. Comm’r, 211 F.3d 1269, 6th Cir., 2000 (payments received by the taxpayer were compensation for services, not loans)
■ Veterinary Surgical Consultants, P.C. v. Comm’r, 117 T.C. 141, 2001 (The president of the corporation performed “substantial services”; therefore, the remuneration he received was as an employee whose wages were subject to federal employment taxes.)
■ Joseph M. Grey Public Accountant, P.C. v. Comm’r, 119 T.C. 121, 2002
■ Mike J. Graham Trucking, Inc. v. Comm’r, T.C. Memo 2003-49, affirmed, unpublished opinion, 3rd Cir., 4/7/2004
■ Superior Proside, Inc. v. Comm’r, T.C. Memo 2003-50, affirmed, unpublished opinion, 3rd Cir., 1/28/2004, cert. denied, 125 S.Ct. 60, 10/4/2004)
■ Specialty Transport and Delivery Services, Inc. v. Comm’r, T.C. Memo 2003-51, not appealed.
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