Reasonable Compensation for S Corporation Shareholder/Employees
“Reasonable Compensation” is an issue all Sub S Corporation shareholder/employees must struggle with. The basis for the struggle is tax and how much you must pay. The more a Sub S Corporation shareholder/employee reports as wages, the more taxes the IRS is able to collect. However, failure to provide for reasonable compensation may result in the IRS recharacterizing payments to the shareholder/employee as wages resulting in additional taxes plus penalties and interest. Indeed, if a shareholder/employee reports no wages on which payroll taxes are paid, this could result in criminal charges of tax evasion which may include imprisonment.The IRS writes: The IRS sends this reminder: An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation, before a non-wage distributions may be made to that shareholder-employee [emphasis mine]. This issue has been identified as an area of non-compliance and will receive greater scrutiny in the foreseeable future.
“A 2005 Treasury Department study, Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations, suggests major changes in how S corporations are taxed. The study suggests shareholders owning more than 50% of the S-corporation stock and who are active in operating the S corporation should pay employment taxes on their entire portion of the S-corporation’s earnings. If adopted as legislation, this would be a major blow to small businesses which operate as S corporations…
The proposed S corporation tax changes are targeted towards those S corporation officer-shareholders who pay zero salary but who have higher earnings.” [1]
Quoting the 2005 Treasury Department study:
“In summary, inequities exist between the employment tax liabilities of sole proprietors and the employment tax liabilities of the owners of single-owner S corporations. The employment tax methodology applied to S corporations does not properly address the facts and circumstances related to the predominant ownership structure of today’s S corporations. This condition is largely the result of Revenue Ruling 59-221 issued by the IRS in 1959 because the 1958 statute that established S corporations in tax law was silent on the employment tax treatment of the corporate profits.
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Given equal amounts of income subject to employment taxes, owners of single-shareholder S corporations and sole proprietors are similarly situated for employment tax purposes. However, a fundamental and significant inequity is created between sole proprietors and owners of single-shareholder S corporations by the manner in which taxable income is determined, since sole proprietors pay employment taxes as a percent of all profits, while owners of single-shareholder S corporations pay employment taxes on only the portion of profits they unilaterally select as their salaries.”
The IRS Published the following Headliner in August of 2003 which is still their current position.Headliner Volume 53August 28, 2003The Internal Revenue Service wants tax professionals and small business owners to understand the law regarding corporate officers who perform services. By law, officers of corporations are employees for employment tax purposes and their compensation is wages. The IRS has identified that some S corporations, in an effort to avoid employment taxes, are improperly treating payments for services to officers as “corporate distributions” instead of salaries. This attempt to characterize officers as other than employees does not work. This article discusses the tax law and recent court cases related to this issue.
The Internal Revenue Code establishes that a corporate officer is an employee of the corporation for federal employment tax purposes. Code sections 3121(d)(1), 3306(i), and 3401(c) specifically define officers of corporations as employees for FICA (Social Security and Medicare), FUTA (Unemployment), and federal income tax withholding purposes.
Treas. Reg. section 31.3121(d)‑1(b) provides a limited exception to the statutory definition:
Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.
Over the past few years, the Tax Court has decided several employment tax cases holding that S corporation officers are employees.
In Veterinary Surgical Consultants, PC v. Commissioner, 117 T.C. 141 (2001) (Veterinary Surgical I), aff’d consol., Yeagle Drywall Co. v. Commissioner, 54 Fed. Appx. 100 (3rd Cir. 2002), 2003-1 U.S.T.C. ¶ 50141 (3rd Cir. 2002), 90 AFTR ¶ 7744 (3rd Cir. 2002), cert. denied, 1235 S. Ct. 2621 (2003), a veterinarian was president and sole shareholder of an S corporation and generated all of the corporate income through his consulting and surgical services. He was also the only individual who performed services for the corporation. The corporate entity claimed the president received no salary for services performed and argued that amounts paid to the president were distributions of corporate net income, rather than wages. In finding that the president provided substantial services to the corporation and was thus an employee and therefore the amounts distributed to him were actually wages subject to employment taxes, the Tax Court stated:
…[T]he characterization of the payment to [the president] as a distribution of petitioner’s net income is but a subterfuge for reality; the payment constituted remuneration for services performed by [the president] on behalf of petitioner. An employer cannot avoid federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income, rather than wages. Regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments represent remuneration for services rendered.
The Tax Court rejected the corporation’s arguments regarding relief under section 530 of the Revenue Act of 1978, finding that the corporation had no reasonable basis for treating the president as other than an employee. The Tax Court and the 3rd Circuit upheld the IRS’s position that the president was an employee of the S corporation and the corporation was liable for federal employment taxes.
Similarly, in Mike J. Graham Trucking, Inc. v. Commissioner, T.C. Memo 2003-49, the Tax Court held that the president of an S corporation who was also the majority shareholder was an employee. In Graham Trucking, the president drove a truck, solicited business, ordered supplies, entered into agreements, oversaw finances, and generally managed the corporation. The corporation did not make regular payments to the president for his services. Rather, the president took funds from the corporation’s bank account as needs arose and/or paid personal expenses for himself and his family from the account. The Tax Court held that the president performed more than minor services and received remuneration for those services. The Tax Court rejected the corporate entity’s arguments regarding relief under section 530, finding that the corporation had no reasonable basis for treating the president as other than an employee.
In each of five other recent opinions listed below, the Tax Court held that the president and sole (or in one case 50%) shareholder of an S corporation, who performed all the services provided by the corporation, was an employee of the corporation. Accordingly, the amounts the president received from the corporation were wages. In each case, the Tax Court also found that the corporation was not entitled to relief under section 530 because it had no reasonable basis for treating the officer as other than an employee.
- Veterinary Surgical Consultants, P.C. v. Comm., T.C. Memo 2003-48 (same veterinarian as in Veterinary Surgical I – see above cited case)
- Superior Proside, Inc. v. Comm., T.C. Memo 2003-50 (siding contractor & remodeling service)
- Specialty Transport & Delivery Services, Inc. v. Comm., T.C. Memo 2003-51 (trucking business)
- Nu-Look Design, Inc. v. Comm. T.C. Memo 2003-52 (home improvement company)
- Water-Pure Systems, Inc. v. Comm., T.C. Memo 2003‑53 (sales of water purification systems)
Other courts have also recognized that an officer of a corporation is an employee for employment tax purposes. In Spicer Accounting, Inc. v. United States, 1988 U.S. Dist. LEXIS 16891 (D. Idaho 9-1-88), aff’d 918 F. 2d 90 (9th Cir. 1990), an accountant, who was the president and owner of an S corporation, sued for a refund of the employment taxes paid for the president/shareholder of the S corporation. The president provided all of the accounting services for the corporation and signed all tax returns completed by the corporation. The accountant did not have an employment contract with the corporation. The accountant did not receive any salary from the corporation, but received “dividends”. The court found that the accountant provided substantial services that were essential to the corporation, he was an employee (not an independent contractor), and the dividends were actually wages subject to employment taxes.
In Joseph Radtke, S.C. v. United States, 712 F. Supp. 143 (E.D. Wisc. 1989), aff’d 895 F.2d 1196 (7th Cir. 1990), another refund suit, an attorney/president/sole shareholder took money by having the board declare a dividend and writing a corporate check to himself. The court held the “dividends” were wages and that the employer could not be permitted to evade employment taxes by characterizing remuneration as something other than wages.
These cases emphasize the courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive remuneration are employees whose compensation is subject to federal employment taxes.“November 2005 The IRS announced that the number of tax-return audits in 2005 increased by over 20 percent, to 1.22 million, the highest number in seven years. IRS Commissioner Mark W. Everson said “Part of the increases comes from improved procedures and part from a new emphasis on enforcement,” he said. The IRS budget increased 4.3 percent for 2006 with a nearly 8 percent increase for enforcement. The Wasington post published this about the 2007 budget ‘The IRS, after years of shifting resources to improve taxpayer service, has come under fire for what critics see as inadequate attention to enforcement. So the agency has been swinging back in recent years, and that trend would continue next year as budget authority for taxpayer assistance, return processing and other management functions would decline 1.2 percent, while enforcement would rise by 1.8 percent.’The years (15 or more) where we have seen a ‘kindler & gentler’ IRS with very few audits is coming to an end. Congress is sending a message to the IRS. Collect More! So be wary S Corporation owners. The issue of reasonable compensation is an easy IRS target and a large revenue generator for the IRS. Consider contacting a local employment agency, provide them with a list of your management responsibilities and hours worked and have them put into writing what it would cost to hire a person to fill your shoes and keep this paper in the same file where you keep a copy of your tax returns.S Corp owners may withdraw earnings from the business as:
- distributions from S corporation earnings (similar to dividends of a C corporation)
- wages
- repayment of loans
- reimbursed expenses
Distributions from an S Corp are not subject to FICA and Medicare taxes. This translates to a potential savings of up to 15.3%. Withdrawals in the form of distributions (dividends) are still subject to federal taxes at the ordinary income tax rates – top tax bracket 35% (Recently tax changes provide for a tax break on C corporations dividends -top rate of 15% – but this does not apply to S corporation distributions.)Wages are subject to FICA and Medicare payroll taxes (15.3%) and are subject to ordinary income tax rates. But the bonus to paying wages opens up the opportunity to fund a pension that will save federal taxes at the ordinary income rates (top tax rate 35%). Pension rules generally permit funding a pension as a percentage of your wage ( Distributions are not wages and therefore are not counted in the pension contribution calculation). The tax savings will continue when money is contributed to a pension because the pension will grow tax free until retirement (compounding the growth of the investment).Loans should be repaid with reasonable interest which is subject to income tax but (interest) is deductible as a business expense. So, as an average taxpayer you will have not have an increase in taxes as a result of the interest paid, but this is a bit of bureaucracy which we recommend you follow. Paying interest will provide support that the loan is arms length and not a disguised capital contribution. Good business practice dictates that when you lend money to your corporation you must get a formal Note (in writing). If you want the loan repaid without tax consequence, you will follow these guidelines. Most business owners will fund the start-up checking account with money from their personal accounts. A portion of these funds should be allocated on the balance sheet as a capital contribution (payment for the purchase of company stock). The amount allocated to Capital should be a reasonable value ( for example $1000 for a service business, more for a business that requires significant purchases of inventory or machinery). The remainder invested may be repaid as a loan provided there is a note drawn and interest payments are made at regular intervals at a reasonable rate of interest according to the note document. Lack of interest payments would infer the debt is contingent upon corporate profits, which is considered a second class of stock. A second class of stock will permit the IRS to discard the S election and submit your company to C corporation taxes (double taxation.)Expenses paid from an owners pocket can be repaid to the S Corp owner with a company check. Just a side note – try to pay the vendor/ payee directly with company funds. There could be more scrutiny with reimbursed expenses than payments directly from the business account . For charge cards used for both personal and business purposes, send 2 checks, one from your personal account to pay personal charges and one from the business account to pay business expenses.”[2]Wages and Distributions comparedLet’s take the example of a shareholder/employee who will earn after expenses (but before wages) $90,000. For every dollar his wage falls below the social security limit he and his company saves a combined 15.3 cents in payroll taxes. We will look at five different options for allocating the earnings between distributions and wages.Strategy 1 – All DistributionHere we will assume that the shareholder/employee drew out and reported all the net income as a distribution. Although this option is not legal, it results in the lowest overall tax. This results in a cash outflow of $31,500.
| Tax Type | Calculation | Tax | |
| Income Tax | $90,000 X 35% | $31,500 | |
| Total Tax | $31,500 |
Strategy 2 – Distribution and WagesWages of $90,000One option is to report all of the net income of the S Corp as wages. This is the worst legal option in that it results in the highest tax. This results in a cash outflow of $45,270.
| Tax Type | Calculation | Tax | |
| Income Tax | $90,000 X 35% | $31,500 | |
| FICA Tax | $90,000 X 35% | $13,770 | |
| Total | $45,270 |
Strategy 3 – Wages of $50,000 and a distribution of $40,000This option is legal and will result in a tax savings of $6,120. The only question would be if the IRS agreed that the $50,000 of wages was enough. This results in a cash outflow of $39,150.
| Tax Type | Calculations | Tax | |
| Wages | |||
| Income Tax | $50,000 X 35% | $17,500 | |
| FICA Tax | $50,000 X 15.3% | $7,650 | |
| Distribution | |||
| Income Tax | $40,000 X 35% | $14,000 | |
| Total | $39,150 |
Strategy 4 – Distributions and Wages and Retirement PlanWith this option, the shareholder/employee will draw wages of $50,000 and a distribution of $40,000 and will make a $12,500 contribution to a SEP retirement plan. Contributions to a qualified small business retirement plan are subject to Social Security, Medicare, and Unemployment taxes but not to income taxes. This results in a tax savings of $10,495 over Strategy 2 ($45,270 – $34,775) and a savings over Strategy 3 of $4,375 ($39,150 – 34, 775). This results in a cash outflow of $47,275 ($12,500 + $34,775). Of course the $12,500 is still yours but it can not be withdrawn without penalty until you reach the age of 59½.
| Tax Type | Calculations | Tax | |
| Wages | |||
| Eligible SEP Contribution | $50,000 X 25% = $12,500 | ||
| Income Tax | $50,000 – $12,500 = $37,500 X 35% | $13,125 | |
| FICA Tax | $50,000 X 15.3% | $7,650 | |
| Distribution | |||
| Income Tax | $40,000 X 35% | $14,000 | |
| Total | $34,775 |
Strategy 5 – All Wages and Maximum Retirement ContributionThis results in the second smallest tax liability costing $2,620 more in taxes than Strategy 4 but results in additional contributions to retirement of $10,000. The interest earned on the additional $10,000 will be tax free until withdrawn. The cash outflow for this strategy is $59,895. There again, the $22,500 is still yours it is just in a place you can not touch until you turn 59½ without penalty.
| Tax Type | Calculations | Tax | |
| Wages | |||
| Eligible SEP Contribution | $90,000 X 25% = $22,500 | ||
| Income Tax | $90,000 – $22,500 = $67,500 X 35% | $23,625 | |
| FICA Tax | $90,000 X 15.3% | $13,770 | |
| Distribution | |||
| Income Tax | $0 X 35% | ||
| Total | $37,395 |
Despite the strategy you choose to adopt, the primary consideration remains “Reasonable Compensation.” There is no safe harbor rule one may follow to avoid an IRS challenge to what you claim as wages as opposed to compensation.Other factors determining reasonableness include: (These are important and your position should be defined before determining your gross wage.)
- the employee’s qualifications and role in the company, including factors such as hours worked the employee’s position, duties performed, and his overall contributions to the company
- the character and condition of the company, including factors such as the size of the company, the complexity of its business and the general economic conditions
- a comparison of the employee’s compensation with the compensation paid by similar companies for comparable services
- ability and achievements of the employee (would an outside investor have paid the compensation amount based on performance);
- volume of business handled by the employee;
- complexities of the business;
- relationship of compensation to gross and net income of the business;
- living conditions in locality;
- the salary policy of the company for all its employees and the particular employee’s salary history with the company
[1] From an article that appeared in the January 2004 issue of National Litigation Consultants’ Review.
[2] Qbalance.com
