Hot Issue with the IRS: Reasonable Compensation and S Corporations

S Corporations have very specific requirements when it comes to taxation and compensation. Where C corporations have the simple obligation of paying their own taxes on taxable income, S corporations financials – whether profit or loss, credits or debits – are split up on a pro rata basis between the individual tax returns of each of its shareholders. The shareholders each accept these distributions without them being subjected to the Social Security and Medicare taxes that self-employed individuals are required to pay on income. This has led many of those responsible for payroll and bookkeeping at S corporations to make the mistake of failing to provide those shareholders with W-2 wages. The tax laws say that these individuals are required to take reasonable compensation – for which they do have to pay Social Security and Medicare taxes - for what they do for the company. In most cases the company will split those taxes with their shareholder, and will also take care of paying any state and federal unemployment taxes for those individuals, as the tax code specifically states that officers of S corporations are to be considered employees for that purpose. The combination of distribution and required compensation frequently lead to problems, as many companies try to identify officer compensation as a distribution in order to avoid paying the unemployment tax.

If you are new to the world of S-corporations and find these rules confusing or frustrating, you’re not alone. In fact, the issue has been a problem since 1974, when the Internal Revenue Service first decided that when shareholder/employees of S corporations fail to take a salary or the salary that they take is unreasonable, it triggers an auditor statement of unreasonableness and leads to the officers distributions being reclassified as compensation from which appropriate employment-related taxes should be paid. This can represent a significant hit, and can include Medicare payroll taxes (1.45%), Social Security (6.2%), any matching amounts from the S corporation, state taxes, Federal Unemployment taxes, and any penalties that may apply.

To avoid this becoming an issue it is important for all involved to understand the rules, definitions and requirements, including the following:

• Officers of S Corporations are Considered Employees, even if they are shareholders. This means that all forms of compensation, whether dispersals or wages, are treated as wages as long as the individual is being paid for services that are considered more than minor. Those wages are subject to all appropriate wage-related taxes, with the only exception coming into play for those officers who are not considered employees because they either provide no services at all or only minimal services.
• Reasonable salaries’ definition is loosely spelled out on Form 1120S (U.S. Income Tax Return for an S Corporation. The definition reads as follows:“Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” The fact that the definition is so vague has led to multiple rulings and lawsuits to try to determine exactly what the tax code means when it refers to reasonable salaries, and though there is still no firm definition, there have been specific elements that are accepted as what the definition should be based on in each individual case. These factors include what the individual officers duties and responsibilities are; what kind of training and experience they have; how much time they invest in the business; what kind of dividends the S corporation has historically distributed, as well as what they pay in compensation to non-shareholder employees; how often bonuses are paid to key employees and what those bonuses are; what similar businesses pay for similar services and what formula they use; and what the company’s compensation agreements provide. 

Though this list may seem comprehensive, the lack of specificity leaves S corporations vulnerable to being told that whatever they elect to do does not measure up and is considered to fall outside of the definition of reasonable compensation – and unfortunately there is ample evidence of this type of unpredictable scrutiny coming into play when it comes to S corporation tax returns.

Changes for 2018

To make matters even more complicated, the tax reform law passed at the end of 2017 has added yet another element: a flow-through deduction that applies to numerous types of business entities, and which is making things even more complicated for everybody trying to figure out how it works.

• Called the “199A deduction,” the new rule dictates that S corporation employee stockholder’s wages are not eligible to be listed as qualified business income that the taxpayer can take as a 199A deduction, even though the S corporation is supposed to list these wages as a deductible business expense when figuring out the amount of profit that is being distributed as qualified business income on Schedule K-1. The new rule means that S corporations are likely to reduce the salaries that are being paid to stockholders to that they can increase their flow through income, which in turn decreases payroll taxes paid by both the company and the shareholder, as well as boosting the shareholder’s 199A deduction.

• Many S corporation shareholders are high wage earners. The 199A deduction has a phased-in wage limitation that starts when taxpayers who file single have 1040 taxable income over $157,500 or $315,000 for joint filing statuses. Once that income exceeds $207,500 or $415,000 respectively, the 199A deduction is completely phased in, and the taxpayer needs to calculate whether their wage limitation or 20% of qualified business income is lower: whichever is lower becomes the 199A deduction. The 199A deduction is eliminated completely when the wage limitation calculates to nothing.

To determine the wage limitation calculation is based on all of the corporation’s wages paid, both to employees and shareholders, as well as the unadjusted cost of the qualified property that the company owned and used during the tax year. Once all of these numbers have been assembled, what needs to be determined is whether half of wages paid is larger or smaller than a quarter of all paid wages plus the calculation of 2.5% of the qualified property’s unadjusted costs. Whichever is larger is the wage limitation.

What all these calculations translate into is the absence of a 199A deduction for shareholders for whom the wage limitation applies who are involved in S corporations that own no qualified property and pay no wages.

Another distinction that the IRS makes restricting the 199A is for S corporations defined as specified service trades or businesses. These include businesses considered to be dependent upon the reputation and/or skill, which may include those in the field of law, health, actuarial science, accounting, athletics, performing arts, financial services, consulting, and brokerage services. In these cases shareholders also phase out starting at $157,500 for singles and $315,000 for joint filers, and completely at $207,500 and $415,000 respectively. This works out well from the standpoint of the reasonable compensation requirement, as because the wage limitation provides them with no benefit, they can go with a lower compensation and pay lower taxes. 

Again, the problem is that these rules are so unclear – it is not up to the taxpayer whether the IRS will consider compensation reasonable or not. The best that any individual can do is to look at all of the factors that the IRS says are weighed and do a careful calculation that is geared towards staying within what the IRS will find acceptable. The more data you can collect to support the compensation figure that is used, the better the likelihood that you will be able to defend your calculation in the face of an audit.

The complexity of these issues makes it especially important that you seek professional help before making any decisions that might get you into trouble. If you are an S corporation shareholder (or are making the decisions about S corporation shareholder distributions), make sure you check with an expert.

 
Frank Jenkins, CPA writes for CountingWorks, an accounting news and advice website. Reach him at [email protected].

 

 

 

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