S-CORP SHAREHOLDER EMPLOYEES, WATCH THOSE DISTRIBUTIONS

S-CORP SHAREHOLDER EMPLOYEES, WATCH THOSE DISTRIBUTIONS

So you’ve evaluated a number of business structures and decided that as a sole employee, a Subchapter S Corporation is the most advantageous for your business. Not only does it offer the personal liability protection of the traditional corporation structure, but income passes through to the individual shareholder. And, not only can you take compensation from the corporation as an employee, the IRS allows you to take a distribution. And even more fantastic than that is a distribution results in more favorable tax consequences than does compensation making the “should I take compensation, a distribution, or both?” question pretty easy to answer.  And it’s at this point where a problem arises.

MORE ON THE PROBLEM

When a shareholder employee takes a distribution, no payroll tax is paid by the corporation nor does the employee pay self-employment tax.  And while the employee pays taxes on all the income that passes through the corporation, the net tax yield by the IRS is less than if the corporation paid compensation in which payroll taxes were deducted and the employee paid self-employment taxes. Naturally for the shareholder employee then, money flowing from the corporation to the employee is better classified as a disbursement than salary. On the other hand, more money flows to the government when characterized as compensation. What results are disagreements between employees taking a distribution and the IRS thinking it should be compensation.

SO WHO GETS TO DECIDE, COMPENSATION OR DISTRIBUTION?

Your immediate reaction might be the government. However, the government has attempted to strike a balance between its interest and the interests of shareholder employees. So, to ensure that it gets its fair share, the federal government requires that shareholder employees in an S Corp take “reasonable compensation” in the form of a wage. And since there is no incentive to characterize income as compensation as indicated above, you would be correct in assuming that what “reasonable compensation” means is the subject of much debate.

WHAT IS “REASONABLE COMPENSATION”?

Like many issues in the law, there is no definite answer. Rather what is reasonable is based on myriad factors. But with guidance by both court decisions and the IRS, we can get a little more comfortable with what reasonable compensation means.

WHAT THE IRS SAYS

The IRS has attempted to provide some guidance.  It suggests one way to evaluate reasonable compensation is to look at an S corporations’ gross receipts which can generally come from three major sources: 1) services of shareholder, 2) services of non-shareholder employees, and 3) capital and equipment. The IRS suggests that if gross receipts arise primarily from 1, it is more appropriate for shareholder employee income to be characterized as compensation. The IRS’s premise is that the more closely associated the shareholder employee’s efforts are to corporate revenue, the less likely it should be treated as a distribution.

The IRS has also listed a set of factors to be considered in determining whether compensation is reasonable. They include:

  • 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

WHAT THE COURTS SAY

While very dependent on the facts of each case, court decisions can also be helpful in determining what reasonable compensation means. Some factors considered are:

  • Compensation earned by others in the profession for equivalent services and level of responsibility

  • The relationship between services rendered and compensation

  • Years of experience

  • Employee education

  • Private and public data on employee compensation

In most court cases, the disparity between what was claimed as compensation v. distributions was significant. In some instances compensation was only 10-20% of the distribution taken. In most cases the employee played a significant role in the revenue of the business while occupying leadership positions. And nearly all cases were for personal services.

WHAT’S THE CONSEQUENCE?

If the IRS determines that distributions should have been compensation, the IRS will recharacterize the distribution and calculate your tax liability based on the recharacterization. What will follow is a tax bill for payroll taxes on the recharacterized compensation along with what could be very substantial penalties. It’s a situation you surely want to avoid.

WHAT SHOULD SHAREHOLDER EMPLOYEES DO?

The first step is to understand your role in the S Corp and its contribution to revenue. I also advise that you gain an understanding of what your contemporaries earn for providing similar services with a similar level of education, expertise and experience. Then, work with your tax consultant or legal counsel to determine what is reasonable under the circumstances. While it’s not possible to avoid a recharacterization entirely, taking reasonable compensation after being fully informed and working with professionals will provide your best opportunity to remain audit and penalty free.

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

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