Many business owners think they are undercompensated. For many S Corporation shareholders, the Internal Revenue Service would also agree, but from a different perspective. That is, whether S Corp shareholder-employee compensation is “reasonable”.
Here’s the issue.
Business owners can elect S Corp status, which still provides limited liability to shareholders, but earnings are taxed directly to the shareholders on their personal returns. (Note: shareholders in a professional corporation still have personal malpractice liability in a law suit).
The advantage of operating as an S Corporation has become magnified as employment tax rates have climbed. Why? S Corp income is not subject to self-employment tax, creating increasing motivation for shareholder-employees to minimize their salary in favor of distributions.
In response, the IRS has made “reasonable compensation” a central focus on audits going after S corporation shareholders who do not pay themselves reasonable compensation to avoid paying employment taxes. If successful, the IRS can collect payroll taxes on officer compensation. The penalty for which can be steep: 100% of the taxes owed.
Taxpayers have not fared particularly well in litigation with the IRS. The burden of proof is on the taxpayer to prove their compensation is reasonable. Courts have based their decisions on the facts and circumstances of each case considering some of the following factors:
- 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
- The use of a formula to determine compensation
There are a number of steps S Corp shareholder-employees can take to make the case that their compensation is reasonable. That’s a job for their CPA or attorney.
Our job is relatively simple. It’s to point out or remind the shareholder-employee that only compensation that appears on the owner's W-2 counts as compensation for purposes of determining a contribution to a qualified retirement plan. The larger the salary, the larger the potential retirement plan contribution.
There is still time before year end.
This article should not be considered legal or tax advice. Taxpayers should always consult with their tax advisors on the application of the tax laws to their specific situation.
Jerry Kalish is an EBA Advisory Board member and President of National Benefit Services, Inc., a Chicago-based third party administrator. He is a Guest Lecturer at John Marshall School of Law LLM Program in Employee Benefits and serves on the Great Lakes IRS Advisory Council for Tax Exempt and Government Entity Plans. Jerry has been publishing The Retirement Plan Blog since 2006. He can be reached via email at firstname.lastname@example.org and followed on Twitter
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