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.

 

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.

 

Partnership Loss Limitations

Deductible Losses Cannot Exceed Your Partnership Basis

Your deductible share of partnership losses may not exceed the “adjusted basis” in your partnership interest.  If your share of the loss exceeds your basis [essentially your net investment-to-date, plus your share of partnership earnings (or minus your share of partnership losses), minus your withdrawals from the partnership], the excess loss amount may not be deducted until you have additional partnership earnings or make additional capital contributions sufficient to cover the excess loss (in the subsequent year(s)).  A partner will also have basis for loans made to the partnership for which he or she is personally liable.

Example:

Year 1

Jim is a 25% partner in the PJQ Partnership.  In Year 1, he invests $5,000 for his partnership interest.   His share of the partnership loss in Year 1 is $2,500 and he withdrew $1,000 from the partnership in Year 1 for personal expenses (this is considered a “distribution” to Jim).  His adjusted basis at the end of Year 1 would be $1,500 ($5,000-$2,500-$1,000).  Since he still has a positive adjusted basis at the end of Year 1, he would be allowed to deduct the full $2,500 loss on his personal return (taken from the Form 1065 K-1 he receives from the partnership).

Year 2

In Year 2, Jim is still a 25% partner.  He adds an additional $1,000 to his capital investment account during the year and makes no withdrawals.  At the end of Year 2, Jim’s share of the partnership loss is $3,000.  At the end of Year 1, Jim had adjusted basis of $1,500 (which carried forward to the beginning of Year 2) plus he added $1,000 to his capital investment, giving him an adjusted basis of $2,500 before he deducts his share of the Year 2 loss of $3,000.   Since his share of the loss exceeds his adjusted basis by $500 ($2,500-$3,000), he can only deduct the amount of the loss that brings his basis down to zero, or $2,500, on his personal return for Year 2.   The remaining $500 loss is disallowed for the current year and carried forward to subsequent tax years until Jim’s basis has been restored (by additional capital contributions and/or his share of partnership profits) to cover the loss.

The above example represents the fundamental changes in a partner’s interest in a partnership.  There will be other adjustments to each partner’s basis depending on the activities of the partnership and the activities of each partner during the year.

It is absolutely essential that each partner keep track of his or her basis adjustments each year, beginning in Year 1, and until the partnership is either dissolved or the partner terminates his or her interest in the partnership.  The burden is on the partner (“taxpayer”) to substantiate his or her basis at the end of each year that he or she is active in the partnership (your documented partner basis history).  If your return is selected for examination by the IRS and you have deducted partnership losses, you WILL be asked for your basis calculation history to substantiate the loss.

Usually, if you are invested in a partnership, you will have retained a competent tax advisor who will prepare each year’s basis documentation and who will also maintain a complete history of your investment in the partnership.  This history is also very important if you wish to terminate your interest in an on-going partnership or when the partnership is dissolved.

It was my experience, as an IRS auditor, that well over 50% of “small” business partnership (defined as less than $10 million in assets) investors had either no documentation or incomplete documentation regarding their basis.   Without this substantiation [including very credible (and expensive) reconstructions], partner losses taken on the examined personal returns were disallowed.

Best advice:  track your partnership basis from day one until you leave the partnership or it dissolves.

Webinar – Tax Solutions for Writers and Authors

On November 15, 2012, I will be making a webinar presentation to published and non-published writers and illustrators on the basics of how to manage their taxes.   The event is sponsored by New Leaf Literary and Media, Inc., New York, NY, for their clientele.

Tax

Tax (Photo credit: 401(K) 2012)

 

 

 

Self-Employed Professionals and Foreign Income – Part 3

Foreign Earned Income

To claim the foreign earned income exclusion or the foreign housing deduction (only when paid from self-employed earnings), you must have foreign earned income.   Foreign earned income generally is income you receive for services you perform during a period in which you meet both of the following requirements:

  • Your tax home is in a foreign country.  (Covered in Part 1 of this series).
  • You meet either the bona fide residence test or the physical presence test.  (Covered in Part 2 of this series).

As a self-employed professional, your foreign earned income includes your professional fees earned and business profits.   The source of your earned income is the place where you perform the services for which you received the income.  Foreign earned income is income you receive while working in a foreign country.  Where and how you are paid has no effect on the “source” of the income.  For example, income you receive for work done in Austria is income from a foreign source even if the income is paid directly to your bank account in the United States.

Royalties received by a writer, author or illustrator are earned income if they are received:

  • For the transfer of property rights of the writer in the writer’s product, or
  • Under a contract to write a book or series of articles.

Such royalties are reported on Schedule C for the self-employed writer, author or illustrator.

Foreign Earned Income Exclusion

Your foreign earned income exclusion is limited to your foreign earned income minus your foreign housing deduction.  You may be able to exclude up to $95,100 in 2012 ($97,600 in 2013) of your foreign earned income.  For 2012, you cannot exclude more than the smaller of:

  • $95,100, or
  • Your foreign earned income for the tax year minus your foreign housing deduction.

EXAMPLE:  You are a self-employed professional living and working in a foreign country and meet the bona fide residence or physical presence test.  Your net earnings (profit) from self-employment (after all business expenses) shown on Schedule C is $105,000.  You are allowed to deduct your foreign housing deduction of $9,084 (see Foreign Housing Deduction Example below) from this amount leaving a balance of $95,916.  Of this amount, you would be allowed to exclude $95,100, leaving only a balance of $816 subject to income tax on your U.S. Form 1040. Your personal exemption, allowed on your U.S. Form 1040, would offset this amount.

Income tax

Income tax (Photo credit: Alan Cleaver)

Foreign Housing Deduction

As a self-employed professional, you are allowed a foreign housing deduction to the extent these expenses were paid for by your self-employment earnings.  As with the foreign income exclusion, your tax home must be in a foreign country and you qualify as a bona fide resident or meet the physical presence test.

The Floor and the Ceiling

Your housing amount is the total of your housing expenses (such as rent, utilities, property insurance, rental of furniture and accessories, and residential parking) for the year minus the base housing amount.   The computation of the base housing amount is tied to the maximum foreign earned income exclusion.  The amount is 16% of the exclusion amount (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the maximum foreign earned income exclusion is $95,100 per year; 16% of this amount is $15,216 or $41.57 per day.   To figure your base housing amount if you are a calendar-year taxpayer, multiply $41.57 by the number of your qualifying days.  Subtract the result from your total housing expenses (up to the applicable limit) to find your foreign housing deduction amount.

Your qualified housing expenses are generally limited to 30% of the maximum foreign earned income exclusion (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year.  For 2012, the standard ceiling would be $28,530 ($95,100 times 30%), or $77.95 per day.  If you live in a high-cost locality, you will be allowed a higher ceiling amount.  The limits for high-cost localities are listed in the instructions for Form 2555.

EXAMPLE:  Your qualifying period includes all of 2012.  During the year, you spent $24,300 for your housing.  You did not live in a high-cost locality.  Since your actual housing expenses do not exceed the standard limit ($28,530), your actual housing costs ($24,300) minus the base housing amount ($15,216), or $9,084, will be your foreign housing deduction.

The housing deduction cannot be more than your foreign earned income minus your foreign earned income exclusion.  You can carryover to the next year (and the next year only) any part of your housing deduction that is not allowed because of the limit.  Situations involving married couples (both having foreign earned income) or involving separate households in a foreign country or countries will require further computations.  This series presents the requirements and benefits for a single, self-employed person.

As a self-employed professional, you will file Form 2555 with your annual return.  You are not eligible to use Form 2555-EZ.

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In Part 4, the conclusion to this series, I will review where items are reported on your return, discuss how self-employment taxes are handled, and provide some helpful resources.