Classic IRS audit redflags include: 1) Failure to report all taxable income; 2)Claiming large charitable deductions; 3) Home office deduction; 4)Business meals, travel and entertainment; 5) Reporting a Small Business Loss; and 6) Math errors and too many round numbers. An additional area of concern for S-Corp shareholder- employees is the “reasonableness” of their employee salary in relation to their shareholder distributions.
Taking a step back, let’s review the tax treatments of various business associations. C-Corps are taxed at the corporate level. While S-Corps and LLCs are similar in that they are both “pass-through” entities for tax purposes, the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a C-Corp. Consequently, most small businesses are organized as either LLCs or S-Corps. An important factor that differentiates an S-Corp from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self- employed and, as such, must pay a self- employment tax of 15.3 % which goes toward Social Security and Medicare. The entire net income of an LLC is subject to self- employment tax. In an S-Corp only the salary paid to the shareholder- employee is subject to employment tax. The remaining income that is paid as a distribution is now subject to employment tax. Therefore, there is the potential to realize substantial employment tax savings depending on the classification of income.
So for the S-Corp shareholder- employee, the question becomes what portion of is business income should he pay to himself as employee salary, subject to employment taxes, and what portion should he receive as distributions, free of employment taxes. While recognizing that Social Security and Medicare are valuable programs and that an individual’s benefits under each are in larger part based on contributions, it is clear that many S-Corp business owners have an incentive to avoid a “self- employment tax” of 15.3 %. Before responding that he should allocate zero to his employee salary, taking all business income as distribution, be aware that the IRS is aware of this disparate treatment of salary and distributions and actively seeking out abusers. In fact , the quickest way to get audited as an S-Corp is to file an 1120S tax return with no amount showing on line 7 “Compensation of Officers.” Nobody works for free.
The IRS has the ability to recharacterize distributions to the S-Corp shareholder- employee as wages for the employment tax purposes. In Revenue Ruling 74-44 the IRS ruled that two shareholders of an electing small business corporation(S-Corp) arranged to receive dividends instead of reasonable compensation for services they performed. That revenue ruling held that the “dividends” constituted wages and were therefore subject to FICA, FUTA and federal income tax withholding. Multiple courts have confirmed the IRS’s ability to adjust the employment tax obligations of S-Corps under this theory. See David E. Watson P.C. v. United States, No. 4:08 cv-442 (S.D. Iowa 2010) (finding that CPA reporting only $24,000 in salary while receiving annual distributions of $91,004, leading to distributions of $67,044 being classified as wages).
So what should the S-Corp owner pay himself as salary?
Reasonable Compensation. The IRS has provided guidance in Fact Sheet 2008-25. The IRS states therein that there are no specific guidelines for reasonable compensation within the IRS Code or regulations. The IRS further explains that each case is different based on the independent factors as well as specific nature of the case. Regardless, the Fact Sheets explicitly states that S-Corps should treat payments for services to officers as wages and not as distributions of cash and property, unless they perform no or minimal services. Although we are without specific guidance to determine whether compensation is reasonable, the fact sheet lays out the following as factors that the courts have addressed:
- Training and experience;
- Duties and responsibilities;
- Time and effort devoted to the business;
- Dividend history;
- Payments to nonshareholder- employees;
- Timing and manner of paying bonuses to key people;
- Payment by comparable businesses for similar services;
- Compensation agreements; and
- The use of a formula to determine compensation.
In short, reasonable compensation is commensurate with the services you are adding as an employee of the company.
On one extreme, in a one-man-shop services company (e.g., CPA, website developer, attorney, tailor, etc.) it is hard to argue that 100% of the income is not wages, or self-employment income. As you add partners, employees and contractors it becomes less clear what portion should be distributions of business income. Therefore, it is important to consider a number of factors, including those listed above, in setting reasonable compensation for shareholder-employees of an S-Corp. Those intent on pushing the envelope would be well advised to have their accountant’s and attorney’s numbers on speed dial.