
S Corporation shareholders enjoy limited personal liability and a beneficial pass-through structure; income and losses pass through the corporation to the owner’s personal tax returns. With this tax structure, shareholder distributions from an S corporation aren’t treated as self-employment income, thereby avoiding the high self-employment tax rate on their share of the income. This allows for savings on payroll taxes since such taxes are not paid on shareholder distributions. However, an S corporation shareholder performing more than minor services for the corporation is considered an employee for tax purposes, as well as a shareholder, and needs to be paid as such. The IRS is paying close attention to S corporations, and when shareholders aren’t paid a reasonable salary, it’s a major red flag, and the likelihood of an audit goes up drastically.
Understanding Reasonable Compensation
To prevent S corporations and their shareholders from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS requires that S corporation shareholders who provide services receive reasonable compensation. The definition of a "reasonable" salary is inherently subjective, which can make determining the correct amount challenging. However, it is essential to understand that this salary should reflect what would be paid to an employee with similar responsibilities in the open market.
To determine a reasonable shareholder salary, consider how you would find a reasonable salary amount for any new employee. The IRS guidelines suggest that you look at the following factors to determine what is a “reasonable” salary for your corporate officers:
Training and experience: The more specialized the skills and experience, the higher the salary should be.
Duties and responsibilities: A shareholder who takes on significant managerial or operational roles should receive compensation commensurate with their duties.
Time and commitment to the business: The amount of time devoted to the business should be directly correlated with the salary. Part-time involvement typically warrants lower compensation than full-time dedication.
Payments to non-shareholder employees: Comparing shareholder-employee salaries to non-shareholder employees can offer insights into what constitutes a fair salary.
Distribution history: A pattern of low salaries paired with large distributions could be viewed skeptically by the IRS.
Timing and manner of paying bonuses to key people: How bonuses are structured and paid can also impact what is considered reasonable.
What comparable businesses pay for similar services: Industry standards are a critical benchmark for setting reasonable compensation.
Documentation and Defense Against IRS Scrutiny
Your ability to substantiate the salaries you are paying shareholders will help keep you on the right side of the IRS when it comes time for them to review your company’s tax returns. Thorough documentation is crucial. Maintain records of industry salary surveys, detailed job descriptions, and minutes from board meetings where compensation is discussed. This documentation demonstrates that the salary decision was made with careful consideration, and in accordance with industry norms, reducing the risk of IRS recharacterization.
If the IRS concludes that an S corporation shareholder has attempted to evade paying payroll taxes by disguising employee salary as corporate distributions, it can re-characterize the distributions as salary and require payment of employment taxes and penalties. These penalties can include payroll tax penalties of up to 100% plus negligence penalties. Additionally, in some cases, shareholders may face the possibility of back taxes being levied, along with interest and additional penalties.
Key Considerations for S Corporation Shareholders
S corporation shareholders should consider the following:
Salaries vs. Distributions: Owners of S corporations should receive paychecks with payroll tax withholdings but also have the option of taking additional money beyond their salary in the form of a distribution. Since the IRS does not confirm a percentage threshold for salary compensation, discuss a reasonable figure with your CPA. As a best practice, avoid paying out distributions that are disproportionate to the salary. A common rule of thumb is ensuring that the salary is at least 50% of the total earnings from the corporation, though this may vary by industry and individual circumstances.
Choose a Reasonable Salary: The IRS is cracking down on S corporations that misclassify payments to shareholder-employees as distributions. Unfortunately, there is no way to guarantee the salaries you set will square with what the IRS thinks is reasonable. But if you do your homework and show that you have made a good faith effort to pay reasonable salaries, the IRS is more likely to defer to your judgment. It might be beneficial to revisit and adjust salaries annually based on changes in the business's financial health, the individual's role, and broader market trends.
Watch Out For Fringe Benefits: Normally, the cost of health insurance premiums for employees is a deductible expense for a business. However, there is a special exception for S corporations, which are not allowed the deduction for health insurance paid for shareholder-employees who own more than 2% of the company. The S corporation must include those payments with its shareholder-employee wages when it issues annual W-2s. By reporting these payments as wages, S corporations are still able to use them as a deduction. Shareholders should also be aware of other fringe benefits, such as retirement contributions or the personal use of a company vehicle, which could also require special treatment under the tax code.
Restrict Stock Ownership: C corporations have virtually no restrictions on who can own stock, but S corporations have quite a few. You can only have a maximum of 100 shareholders and only one class of stock (although you can issue stock that doesn’t have voting rights). Also, you cannot allow a partnership, corporation, or foreign person to be a shareholder. Violating any of these guidelines could cause the IRS to terminate your S corporation status. Maintaining a proper shareholder agreement is essential to ensure compliance with these rules. Regularly review your shareholder roster to ensure no inadvertent violations occur.
Additional Strategies for S Corporation Tax Planning
Since a reasonable salary is a subjective number, you should have some justification for the salary you choose and should consult with your trusted CPA to set an appropriate figure. Counsel can advise you on establishing reasonable compensation for your officers and can help implement the right tax plan to maximize the growth of your business.
Consider Section 199A Deduction: S corporation shareholders may be eligible for the Qualified Business Income (QBI) deduction under Section 199A. This deduction allows eligible S corporation shareholders to deduct up to 20% of their qualified business income from a pass-through entity, subject to certain limitations. Structuring your compensation and distributions correctly can help maximize the benefit from this deduction.
State Tax Considerations: Some states have specific rules for S corporations that differ from federal regulations. For instance, some states do not recognize S corporation status and may tax the entity as a C corporation. Understanding the state-level tax implications is crucial for optimizing your overall tax strategy.
Succession Planning: If you plan to transfer ownership of the S corporation, either as part of retirement or estate planning, it’s essential to consider how reasonable compensation and distributions affect the valuation of the company. Proper planning can help mitigate potential tax liabilities and ensure a smoother transition of ownership.
Conclusion
Navigating the complexities of reasonable compensation for S corporation shareholders requires a nuanced understanding of IRS expectations and careful planning. With the right documentation, consultation with a knowledgeable CPA, and proactive tax planning, you can ensure compliance while maximizing the financial benefits of S corporation status.
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