Shareholder-Employee “Reasonable Compensation” in a S-Corporation

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.

Reasonable Compensation

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

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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.

Court case:

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]

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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.

 

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Who Pays Taxes (and who doesn’t)?

The top 1% of individual filers paid 37.8% of all federal income taxes in 2013, the most recent year IRS has analyzed.  That’s down from 38.1% the previous year.  This group reported 19% of total adjusted gross income.  Filers need adjusted gross income of at least $428,713 to earn their way into the top 1% category.

The highest 5% paid 58.6% of total income tax and accounted for 34.4% of all adjusted gross income.  They each had adjusted gross income of at least $179,760.

The top 10% of filers, those with adjusted gross incomes of $127,695 or more, bore 69.8% of the income tax burden while bringing in slightly less than 46% of individuals’ total adjusted gross income.

The bottom 50% of filers paid 2.8% of the total federal income tax take.

No Deduction Allowed for Substantial Use of RV

Jackson, Tax Court Memo. 2014-160

The taxpayer was an insurance agent who specialized in selling insurance policies specific to recreational vehicles (RVs).  To gain access to RV owners, the taxpayer was a member of several RV clubs.  The clubs held RV rallies which were primarily social events.  Only RV owners could attend these rallies.  Ownership was also required by certain RV parks, which often prohibited RV’s older than a certain age.

The taxpayer gathered sales leads at every rally.  He attached to his RV advertisement promoting his insurance business.  He invited potential customers to come to his RV and discuss the prospective client’s insurance needs.  It would often take months, if not years, for a relationship with a potential customer to develop into an actual sale.

The court stated there was no question the taxpayer used his RV for some personal purposes.  The taxpayer claimed, however, that he was entitled to deductions related to the business use of his RV.

The court acknowledged that the taxpayer actively sold insurance polocies during his time at the rallies, and that business activities conducted in using his RV generated a significant amount of revenue.  After reviewing the evidence in the record and considering the taxpayer’s testimony, the court concluded that the taxpayer spent two-thirds of his time during these rallies on business and one-third of his time for personal pleasure.  Thus, the primary use of the RV was for business, not pleasure.  However, none of the deductions for the business use was allowed because of IRC section 280A.

The Tax Court has previously ruled that an RV qualifies as a dwelling unit for purposes of the office-in-home rules under IRC section 280A.  Under the general rule, any personal use, including watching TV in the RV, makes the entire day a personal day.  IRC section 280A(c) has an exception to this general rule which allows a taxpayer to allocate costs to business use if a portion of the dwelling unit is “exclusively used” on a regular basis “as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business.”  The court said exclusivity is the key to this case.  The taxpayer did not use any portion of his RV exclusively for business.  Therefore, no deduction for the expenses allocated to the business use is allowed.

 

IRS Announces 2016 Standard Mileage Rates

By Gary A. Hensley, MBA, EA

IRS, in Notice 2016-1, announced the optional 2016 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes.

Highlights:

Business mileage:  The standard mileage rate for transportation or travel expenses for 2016 is 54 cents per mile (compared to 57.5 cents in 2015) for all miles of business use (business standard mileage rate).

Charitable mileage:  The standard rate for 2016 is 14 cents per mile (same as 2015) for use of an automobile in rendering gratuitous services to a charitable organization.

Medical care and moving:  The standard mileage for 2016 is 19 cents per mile (compared to 23 cents in 2015) for use of an automobile for medical care or as part of a move (for which the expenses are deductible under IRC 217).

Basis Reduction Amount

For automobiles a taxpayer use for business purposes, the portion of the business standard mileage rate treated as depreciation (when sold or traded in) is 23 cents per mile for 2012, 23 cents per mile for 2013, 22 cents per mile for 2014, 24 cents per mile for 2015, and 24 cents per mile for 2016.

Remember:  A taxpayer is not required to use the standard business mileage but instead may substantiate using actual allowable expense amounts if the taxpayer maintains adequate records or other sufficient evidence.

 

Appearance at 42nd Midwest Writers Workshop

Looking forward to my repeat visit to the 42nd Midwest Writers Workshop at Ball State University in Muncie, IN to talk about the “business side of writing.”  I will be giving classroom lectures on Friday, July 24th and Saturday, July 25th.  I will also be part of a round-table discussion on Saturday morning and have several one-on-one consultation appointments.

The conference is sold out this year.  Lecture topics include “Basic Taxation for Writers” and “Are You a Professional Writer?  Don’t Wait for an IRS Audit to Find Out!”

More about the Midwest Writers Workshop at Twitter @MidwestWriters. or on the web at http://www.midwestwriters.org.

The energy and creativity at this event is awesome!

It’s Time to End (or at Least Reduce) the Taxation of Social Security Benefits

Opinion

Tax Reform Recommendation

By Gary A. Hensley, MBA, EA

As we begin another season of watching political candidates aspire to the presidency, we will be smothered with ideas about how to “save” federal trust funds such as Social Security. Due to the ever-increasing senior citizen demographic (those 62 and older for our purpose here), most candidates will be loath to suggest anything that would impinge on their future benefits (at least until another election has passed). From a strictly political perspective, it’s irresponsible to discuss any type of funding source reduction. Which is another way of saying you will likely only see this point-of-view here.

It’s a two-edged sword—to give seniors more disposable income by not taxing their Social Security benefits is helpful to them, but at the same time it reduces those dedicated tax dollars from going into the fund to preserve its future financial integrity. Ending the taxation of Social Security benefits, however, will have a negligible effect on the final solution needed to shore up the major funding issues associated with Social Security (for example, there are now only two workers for each Social Security retiree) but will have an immediate positive impact on seniors struggling with rising health care costs, food, gasoline, rent or mortgage payments, etc.

For 2011, the most recent year of income by source data available from the IRS, total Social Security benefits reported were $490.7 million (25.8 million returns) and $201.6 million of this was taxable (16.8 million returns). More specifically, for the adjusted gross income range of $25,000 to $75,000, the taxable Social Security benefits totaled $84.3 million (9 million returns). In 2015, single filers could pay as high as 25% on their taxable benefits in this range and married couples 15%.

The taxation of Social Security benefits debuted, in 1984 (Code Sec. 86), during Ronald Reagan’s presidency and was capped at 50% of benefits received. In 1993, the tax cap was raised to 85% of benefits received under President Bill Clinton. Thus, it has been a bipartisan effort to get where we are today.

In 1981 the National Commission on Social Security Reform (sometimes referred to as the Greenspan Commission after its chairman) was appointed by Congress and President Reagan to work on the financing crisis in Social Security. The result of their study included several amendments that were passed by Congress, signed by President Reagan and made into law in 1983.

As originally passed, if the taxpayer’s combined income (total of adjusted gross income, interest on tax-exempt bonds, and 50% of Social Security benefits and Tier I Railroad Retirement Benefits) exceeds a threshold (base) amount ($25,000 for an individual with a filing status of single or head-of-household, $32,000 for a married couple filing a joint return, $0 if married filing separately and the taxpayer lived with his or her spouse at any time during the tax year), the amount of benefits subject to income tax is the lesser of 50% of benefits or 50% of the excess of the taxpayer’s combined income over the threshold (base) amount. The additional income tax revenues resulting from this provision are transferred to the trust funds from which the corresponding benefits were paid.

The 1993 formula amendment increased the maximum due to no more than 85% of benefits (and added a second tier adjusted base amount of $44,000 for married taxpayers filing jointly, $0 for married taxpayers filing separately and not living apart during the entire tax year and $34,000 for all other taxpayers). From 1983 until the present, the cumulative rate of inflation has been 137.5% and, yet, the threshold (base) amounts have never been increased.  

As an example, in 2014, a married couple (both 63 years old), filing jointly, one retired and drawing benefits and the other still working full-time (and not drawing benefits) have the following sources of income: wages at $40,000; interest income of $1,500; taxable pension retiree income of $14,000; and Social Security benefits of $18,000. In this scenario, the couple would be required to report 85% of the Social Security benefits (or $15,300) as taxable benefits on their return! The couple’s taxable income, after the standard deduction ($12,400) and two personal exemptions ($7,900) would be $50,500. Their marginal (highest) tax rate would be 15%. Fifteen percent times the taxable Social Security benefits will add an additional $2,295 to their tax bill.

Although you can ask for federal income tax withholding on your Social Security benefits, most first-timers who owe tax are caught with their pants down and end up with a tax bill (or significantly reduced refund). Also, if you do owe a balance on your federal tax return greater than $1,000, you could be subject to an underpayment penalty!

Thirteen states also tax Social Security income. Some states mirror the way Social Security is taxed on the federal level, while others have their own set of rules that they go by. For those that mirror the federal formula, repealing the tax at the federal level would also eliminate the state tax burden on this income.

One final kick in the pants: In 2015, if you continue to work for wages or have self-employment income and you are drawing Social Security retirement benefits before full retirement age (66), you will be required to pay back to Social Security one dollar for every two dollars you earn in excess of $15,720. Different rules apply for the year you reach full retirement age. Early retirees who continue working may have taxable Social Security benefits (more likely if they are filing a joint return and the other spouse is also working) and yet still be required to pay back some of those benefits for the same year if earnings exceed the Social Security exempt amount.

It’s past time for Congress to repeal the taxation of Social Security benefits. Unlike an IRA or 401k retirement plan, which allows a participant to reduce the current year’s taxable income by the amount of his or her annual contributions, employees received no income tax deduction for mandatory Federal Insurance Contributions Act (FICA) deductions withheld from their paychecks during their working lifetime. Surely this tax provision can be repealed and offset by reducing the billions of dollars of fraud and waste in the federal budget. The federal earned income credit (EIC) program alone has fostered billions of dollars in fraudulent claims that have been paid out and never recovered. In 2013, the IRS estimates it paid out $5.8 billion in fraudulent refunds to identity thieves.

RECOMMENDATIONS (in order of preference):
1. Repeal the taxation of Social Security benefits.
2. Index the income threshold (base) amount to the rate of inflation before Social Security benefits can be taxed. The cumulative rate of inflation since 1983 (when the law was originally passed) to 2015 is 137.5%. That would move the threshold (base) amount immediately for married couples to $76,000 (from the original $32,000) and for singles to $59,000 (from the original $25,000). This would help a substantial segment of our middle-class income seniors have a better quality of life, which they have earned.

Warning! Form 1099-MISC and Payments to LLCs

By Gary A. Hensley, MBA, EA

Most of you are aware that you need to issue a Form 1099-MISC to independent contractors you paid $600 or more for services (not goods) during 2014 no later than February 2, 2015 (also you send a copy to the IRS by March 2, 2015).  The payments reported cover only those payments made in the course of your trade or business.

Many entrepreneurs believe (incorrectly) that if a vendor has LLC or L.L.C. after their company name (meaning limited liability company) that no Form 1099-MISC is required to be sent.  Compounding this belief?  The member(s) of many LLCs will tell those that they have rendered services to that it isn’t necessary or required to send them a Form 1099-MISC.  The requirement to file Form 1099-MISC is the government’s attempt to reduce the multi-billion underground (untaxed) economy.  Thus, if you are required to file a Form 1099-MISC and do not, a penalty will be assessed for each form not filed.  The penalty for not filing or filing late depends on the extent of tardiness.

A LLC can fall into three different categories:  (1) a single-member LLC which is a sole proprietorship (filing Schedule C as part of the individual’s personal Form 1040); (2) two or more members organized as a partnership LLC (filing Form 1065); and (3) one or more members filing as a corporate LLC (either a “C” corporation or a “S” corporation, filing Form 1120 or Form 1120-S, respectively).  Categories (1) and (2) should always be sent a Form 1099-MISC if they provided $600 or more in services to you in 2014.  With very few exceptions, you are not required to send Form 1099-MISC to category (3) organizations.  Most LLCs choose to be taxed as sole proprietors (commonly referred to as a “disregarded entity” in tax-speak) and partnerships.  When in doubt, send a Form 1099-MISC to all vendors you paid $600 or more for services in 2014.  There is no down side in doing so.

One exception that will be relevant to writers, literary agents and publishers:  Any amount you pay in royalties of $10 or more, in the course of your trade or business, requires you to send a Form 1099-MISC.  [Please refer to my article on properly reporting royalties.]

The following steps will help you nail down your compliance in this area:

  1.  Review all your payments for services to each vendor during 2014 and determine who received $600 or more in payments from you.
  2. Review your vendor records to determine if you have the complete name and address for those identified in step 1 above and also that you either have the vendor’s Social Security Number (SSN) or Employer Identification Number (EIN).  If you are lacking any of these critical items, you will need to mail a Form W-9 to the vendor requesting this information.  Keep a copy of the W-9 in your vendor file documenting your attempt to get the needed information along with the date you mailed it.  A USPS Certificate of Mailing is an inexpensive way to show proof of mailing.  In the future, obtain the W-9 information at the time you retain the vendor.  If the vendor refuses to furnish the information or sign the form—buyer beware!
  3. Next, you will use the official IRS Form 1099-MISC for each vendor.  The form is in triplicate with the top copy (shaded in red) going to the IRS and the other two copies going to the vendor and your vendor file.
  4. Finally, you will summarize your Form 1099-MISC information on IRS Form 1096 which you can mail to the IRS or file electronically along with the red copy(ies) of Form 1099-MISC.

You may wish to engage a local accountant or payroll processing specialist to help you with steps 3 and 4.

For additional IRS information on this topic, you may refer to IRS Form 1099 at the IRS website—www.irs.gov.

I hope this article will clarify your reporting requirements and further audit-proof your returns.