To say that tax reform in the United States is currently a controversial topic is a little bit of an understatement. It's also an uncertain one, as nobody is quite sure what the recent wave of massive changes will mean for most people moving forward. One of the biggest recent adjustments to the tax code applies specifically to S Corporation owners. It doesn't just involve how they run their business — it also involves the amount of money they're taking home from that business as well.
Tax Reform and S Corporation Owners: What You Need to Know
One of the most important things to understand about all of this is that the IRS plainly states that S Corporation officers are company employees. Because of this, those companies need to comply with any and all employment laws relevant to those employees. This means that the companies must pay payroll taxes on their salaries, all while withholding federal and state income tax. They also need to pay unemployment taxes, workers compensation taxes and more.
The reason this begins to matter has to do with another point that the IRS is very specific about. They state on their website that “the fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.”
To put it another way, the IRS knows that many S Corporation shareholders try to avoid paying their fair share of employment taxes by minimizing the salaries and bonuses that they pay to corporate officers. Because of this, compensation is one of the first things that the IRS is going to take a look at if they ever show up to your business for an audit. Tax reform has only caused the IRS to take an even closer look at this than ever before, which is part of the reason why paying yourself a reasonable compensation moving forward is of paramount importance.
What Is “Reasonable Compensation”?
Generally speaking, the best way to determine reasonable compensation for yourself (or for any S Corporation employee) begins by taking a look at what reasonable compensation looks like for any new hire you bring on. Thankfully, the IRS provides guidance for this. Their experts suggest that you take a closer look at a variety of factors, including but not limited to ones like
Once all those things are considered, you have a pretty solid starting point for determining what “reasonable compensation” for someone in your position actually looks like.
If you stray from this reasonable figure in an effort to minimize your taxes, it’s likely going to cost you – and your tax preparer – a great deal. One study estimates that the total cost to the taxpayer in fines will likely be more than twice the amount of the original tax you could have just paid to begin with. Your tax preparer could also be subject to a fine or other penalty of around $5,000.
Enter: The Tax Cuts and Jobs Act
Where the Tax Cuts and Jobs Act enters into this conversation has to do with the new Sec 199A deduction. For S Corporations, this deduction only applies to K-1 pass-through income, not to wages paid to the shareholder in question. While this is good news for most people, the working theory is that the appeal of a shiny new 20% deduction will only cause more people to totally ignore the reasonable compensation requirements outlined above. This again means that this is even more likely to become a point of contention if you’re ever audited than it already was.
To help make sure that you’re protected throughout all of this, it’s recommended that you conduct a “Reasonable Compensation Stress Test” to make sure everything is on the straight and narrow. At its core, this is a written report that uses IRS criteria, relevant court rulings, information from the United States Census and the Bureau of Labor Statistics, and other sources to accurately asses the risk you’re exposing yourself to by paying yourself whatever you deem “reasonable” in the short-term. In essence, it’s a bit like auditing yourself before the IRS has a chance to. While there’s no “one size fits all” approach to this, it’ll give you a good indication of how close to the target you really are – or conversely, how far away you stand. Based on that, you’ll have the actionable information you need to correct the issue today before the IRS comes knocking at the door tomorrow.
Sonu Shukla, CPA writes for CountingWorks, an accounting news and advice website. Reach his office at [email protected].
About Sonu Shukla, CPA, CFP
Sonu Shukla is a Certified Public Accountant as well as Certified Financial Planner. He believes in proactive tax planning and has the skills, education and experience to demonstrate passionately planned financial strategies. His firm tailors highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out. Located in Orlando, FL, he services all of Florida.
