Some writers, publishers, illustrators and many other small business owners have been advised (or otherwise selected on their own) to operate as a Subchapter S corporation under the Internal Revenue Code. The S-corporation provides the same limited liability of a “C” corporation; however, the S pays no tax at the corporate level. The income or losses are “passed through” directly to the shareholders (via a 1120S K-1 form) who place these numbers on their personal Form 1040.
In selecting S returns for IRS audit, one of the major issues in being selected is the lack of “reasonable compensation” paid to the shareholder-employee (in the case of a one-owner S corporation) or to all shareholder-employees in relationship to the personal services they provided to the corporation during the corporate year. To further compound this problem, shareholder-employees may be advised (or just think it’s a “cool idea”) to just take cash withdrawals in lieu of a salary (to avoid payroll taxes and payroll recordkeeping).
There are several tricky and sticky areas in handling S corporation transactions; for example, how to handle fringe benefits paid to shareholder-employees or shareholders taking “distributions of cash or other property” in excess of their basis of ownership in the business. I hope to deal with those issues in future pieces. This piece will focus on the requirement that reasonable compensation be paid to shareholder-employees.
Payment for services. S corporations must pay reasonable compensation to a shareholder-employee (issue a W-2) in return for services that the employee provides to the corporation before non-wage distributions may be made to him or her.
Source of gross receipts. Three major sources of an S corporation’s gross receipts are:
- Services of the shareholder;
- Services of non-shareholder employees; or
- Capital and equipment.
If most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. Additionally, the shareholder-employee should be compensated for administrative work performed for the other income producing employees or assets.
Reasonable Compensation in the Courts
Several court cases support the authority of the IRS to reclassify other forms of payments to shareholder-employees as wages subject to employment taxes:
IRS Position: Authority to reclassify
- Glass Block Unlimited, T.C. Memo 2013-180
- Joly, 6th Cir., March 20, 2000
IRS Position: Reinforce employment status of shareholders
- Joseph M. Gray Public Accountant, P.C., 119 T.C. No. 121
- Veterinary Surgical Consultants, P.C., 117 T.C. No. 141
IRS Position: Reasonable reimbursement for services performed
- David E. Watson, P.C., 8th Cir., February 21, 2012
- Sean McAlary Ltd. Inc., T.C. Summary 2013-62
Many S corporations are set up for the primary purpose of avoiding payroll taxes on wages to shareholders. This approach does not comply with tax law. A recent study identified the highest noncompliance issue in S corporations as being incorrect wages paid to shareholders. The growing number of S corporations and the fact that most of them are held by three or fewer shareholders makes this area a prime target for IRS audits. (Treasury Inspector General for Tax Administration Ref. No. 2012-30-062).
Factors Considered in Finding Reasonable Wages
The following factors are often cited in court cases in relation to determining reasonable wages for a S corporation shareholder:
- Training and experience,
- Duties and responsibilities.
- Time and effort devoted to the business,
- Dividend history,
- Payments to non-shareholder employees,
- Timing and manner of paying bonuses to key people,
- What comparable businesses pay to key people,
- Compensation agreements, and
- Usage of a formula to determine compensation.
Salary Comparison Research Tools
One research tool to help determine a reasonable salary is http://www.salary.com. Use the Salary Wizard to determine what others make in a particular line of work in a particular area. Comparable wage information specifically for S corporations can also be obtained here.
One Final Note: You Cannot “Assign” Outside Income to your S-corp
An S corporation does not preclude taxation of income to the service provider (the individual shareholder) instead of the corporation. Income is taxable to the one who earns it.
The taxpayer and his wife each owned separate S corporations under which they ran a tax preparation business and realtor business, respectively. Each taxpayer assigned payments received for their services to their respective corporations. Neither corporation paid either taxpayer wages for their services. Since there was not an employer-employee relationship, nor any contract between the corporation and the taxpayer giving the corporation the right to instruct or control the taxpayer’s actions, the court upheld the IRS’ position that the S corporations themselves did not earn the income. Rather, the taxpayers personally earned the income outside the corporation and, thus, were subject to self-employment tax (treating each taxpayer as a sole proprietor). [Arnold, T.C. Memo 2007-168]
I hope this piece will prove to be helpful to you and your tax and financial consultants. To receive an automatic email alert when future pieces post, sign up for email at the bottom right of my home page at http://www.taxsolutionsforwriters.com.