The major advantage of an S-Corporation is the single level of taxation as a pass-through entity, and the treatment of earnings that designate corporate income as passive income and minimizing self-employment income. The treatment of income from S-Corporations is in stark contrast to that of a general partnership, LLC members and sole proprietors, for whom net earnings from self-employment include any trade or business income and a partner’s distributive share of income from a trade or business carried on by the partnership (Sec. 1402(a)).
However, the IRS does have provisions that require an S-Corporation shareholder, providing services to the S-Corporation, to receive an adequate or reasonable amount of compensation for the services provided. The S corporation is allowed to deduct the compensation expense, including the employer share of employment taxes. The current employment tax rates are 6.2% Social Security tax and 1.45% Medicare tax. The S-Corporation is generally responsible for Federal Unemployment Tax Act (FUTA) and State Unemployment (SUTA) taxes, which are in turn deductible by the corporation. Keeping an S- Corporation’s shareholder wages low and characterizing most of the pass-through income as distributions minimizes the taxes. This is where the IRS takes issue and adjustments may need to be made to be in compliance with IRS code.
The U.S. Government Accountability Office reported in 2009 on employment tax noncompliance among S-Corporation shareholders at high percentages. The IRS has been pursuing this perceived abuse of inadequate compensation in favor of dividend distributions to shareholder-employees and has won a number of cases. One of the most abusive cases to date was Watson v. United States, No. 11-1589 (8th Cir. 2/21/12). The IRS has the authority to reclassify dividends, distributions, or payments to the shareholder-employee, including loan repayments, as compensation if it deems compensation inadequate or unreasonable. The courts have held that the question of reasonable compensation is one of fact, and will be determined on a case-by-case basis.
If you are passive as an owner, you are entitled to claim all of your distributions from your S-Corporation without taking a salary.
IRS fact sheet FS-2008-25, Wage Compensation for S Corporation Officers, lists the following factors in determining reasonable compensation: 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 for similar services, compensation agreements, and the use of a formula to determine compensation. Sources of information on comparable compensation for services include the U.S. Department of Labor’s Bureau of Labor Statistics, employment agencies, and a market analysis. The key in defending a claimed compensation amount is to document all research to support the amount.
Shareholder/officers of a corporation who do not perform any services or perform only minor services in that capacity, and who do not receive or are not entitled to receive direct or indirect compensation, are not considered employees of the corporation. Thus, since most shareholder-officers of closely held corporations do provide more than minor services to the corporation, they most likely are considered employees.
The S-Corporation entity form provides planning opportunities to avoid payroll taxes or self-employment taxes on distributions that are instead a return on capital and assets. With the increase in Medicare tax of an additional 0.9% for high-wage earners scheduled to begin in 2013, this may represent a larger opportunity. The key in defending against a possible audit and recharacterization of dividends is to document all research and analysis of the determination of the shareholder-employee salary.
If you feel this is an area that needs to be addressed within your S-Corporation, please feel free to call and schedule time to discuss your concerns and possible corrections to your characterization of salary and distributions as income.