The IRS has long viewed the issue of S corporation employee-shareholder compensation as a hot topic; one that it has successfully pursued both through the courts and under audit in recent years. While there is no hard-and-fast rule to establish the amount, an S corporation must pay its employee-owners reasonable compensation for services they provide to the corporation. Over the years, the IRS, through legal precedent and government statistics gathering, has established criteria that should be considered in making this determination to minimize the potential risk of future tax assessments and penalties.

A Subchapter S corporation (an S corp.) is a small corporation that has elected to be taxed as a pass-through entity whereby income and losses flow through the corporation to the owner’s personal tax returns in the year earned or incurred. It generally does not matter if, or when the income is distributed to the shareholders.

Advantages of an S Corporation
One advantage of an S corp. over a C corporation is that it eliminates double taxation – once at the corporate level at corporate rates and again as a dividend distribution at individual rates. Besides its single level of taxation as a passthrough entity, another benefit of an S corp. is that a shareholder’s allocable portion of the corporation’s net income is not considered self-employment earnings and is, therefore, not subject to the 15.3% self-employment tax, which is the combined employer and employee Social Security and Medicare rates (all income is, however, subject to income taxes). This treatment differs from that of a sole proprietor, general partner, or LLC member, for whom net earnings from self-employment include any trade or business income, as well as a partner’s or member’s distributive share thereof. As a result, there is no need to determine reasonable compensation for these entities since all of their net profits are subject to self-employment tax.

When Reasonable Compensation Must be Determined
A shareholder in an S corp. who provides services to the corporation wears two hats as both an owner and as an employee. Under this common scenario, the shareholder must receive an adequate or reasonable amount of compensation for these services. The S corp. may deduct the shareholder’s salary and must pay the employer share of employment taxes, including Social Security, Medicare and Federal unemployment taxes (the employee-shareholder pays the employee portion of Social Security and Medicare). There is an incentive, therefore, to classify most of the passthrough income as distributions and to minimize the employee-shareholder’s salary to avoid payroll taxes.

Officers, directors and shareholders who manage an S corporation usually determine the salary structure of the corporation’s employees. As an employee of an S corporation that you own (solely or with others), you, in effect, set your own salary. In fact, one government report noted that 80% of all S corporations are owned by just one person or at least majority owned, in essence, giving the owner complete discretion to decide his or her compensation.

Only in circumstances in which shareholders who are officers of a corporation, but 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. Since most shareholder-officers of closely-held S corps do provide more than minor services to the corporation, they do, in fact, act in an employee capacity. It is, therefore, advisable to receive some salary from your S corp. even if it is at the low end of the reasonableness scale discussed below.

Guidelines for Setting Reasonable Compensation
The IRS requires that S corporations pay reasonable compensation to an employee-shareholder in return for services that he or she provides to the corporation before any non-salary distributions are made. Such compensation shall never exceed the amount that is constructively received by the shareholder (an example of a constructive receipt would be having your S corp. pay your home mortgage directly).

Although the IRS allows an S corp. to decide adequate owner compensation, it has the authority to reclassify distributions, dividends, loan repayments and similar disbursements to the employee-shareholder, as compensation that it deems unreasonable. The courts have held that the question of reasonable compensation is one of fact, determined on a case-by-case basis, but most often within the guidelines set forth by the IRS. If the IRS does conclude that an S corp. has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can require payment of employment taxes and payroll tax penalties of up to 100%, as well as negligence penalties on the amount of the reclassified compensation.

In making this determination, the IRS stresses that it is essential to identify the source of the S corp. gross receipts as they relate to the services and functions that the owner-employee provides to the S corp. The three major sources are as follows:

  1. Services provided by the shareholder,
  2. Services provided by the non-shareholder employees, or
  3. Capital and equipment

Under this criteria, if the gross receipts and profits are generated from –

  • Item 1, then most of the profit distribution should be classified as compensation
  • Items 2 and/or 3, then they are not to be associated with the employee-shareholder’s personal services. It is, therefore, reasonable that the shareholder would receive a higher proportionate share of distributions than compensation

The IRS states that in addition to the direct generation of gross receipts, the employee-shareholder should also be compensated for administrative work performed for the other income producing employees or assets. For example, while a manager may not directly produce gross receipts, he may indirectly assist or support other employees or assets that generate sales. On the other hand, if the S corp. is a service-oriented business such as a medical practice, law firm or plumbing trade, then it stands to reason that ownership is in said profession or vocation and personally provides such services. In that case, most of the profit should be allocated to shareholder salary.
Factors that the IRS and courts consider as they relate to shareholder-employee compensation include:

  • Duties performed
  • Volume of business handled
  • Type of work and amount of responsibility
  • Complexity of the business
  • Time and effort devoted to the business
  • Timing and manner of paying bonuses to key people
  • Use of any formulas to determine compensation
  • Cost of living in the locality
  • Ability and achievements of the individual performing the service
  • Salary as compared to the gross and net income of the business
  • Salary as compared to shareholder distributions
  • Company policy regarding compensation of all employees, and
  • Payment history for each employee

Once the IRS has examined the facts and circumstances, it will establish a range of reasonable salaries. Sources of information on comparable compensation for services include the U.S. Department of Labor’s Bureau of Labor Statistics, employment agencies, recruiting firms and market analysis. Some IRS offices have software that provides salary information for a variety of occupations throughout the country. This salary range will then be compared to shareholder distributions and compensation to determine whether a portion of the distributions should be re-characterized as compensation.

S corporations provide planning opportunities to minimize payroll taxes by establishing a reasonable allocation of its profits between owner-employee compensation for services rendered to produce such profit, and shareholder distributions that conceptually represent a return on owner investment. In fact, the recent 0.9% increase in Medicare tax for high-wage earners that began in 2013 may have indeed provided a greater opportunity to do so. To guard against a possible audit that could result in the re-characterization of dividends and the resultant payroll tax and penalty assessments, it is important to document all research and analysis used in the determination of employee-shareholder compensation within the guidelines that have been established by the IRS and legal precedent.

For more information on S-Corporations or another area of accounting, please contact Victor C. Belgiorno at 516-861-3704 or VBelgiorno@dsjcpa.com or Bob Jahelka at 516-861-3707 or BobJahelka@dsjcpa.com.