Business owners have discovered that selecting S corporation tax status results in business profit not incurring self-employment taxes—the employer and employee shares of Social Security and Medicare.
All shareholders—including those who do not actively participate in management of the corporation—pay regular income tax on their respective shares of business profit. That federal income tax is assessed on each shareholder’s portion of profit regardless of whether the corporation distributes any profit. Shareholders providing services to S corporations incur payroll taxes only on their wage compensation. Unlike active participants in an LLC or partnership, there are no payroll taxes on S corporation profits.
Naturally, this situation draws the scrutiny of the Internal Revenue Service. After all, someone must operate the corporation and therefore is an employee. The IRS wants payroll taxes on some amount of compensation. The general IRS rule is that an owner of a profitable S corporation must receive “reasonable” compensation for services.
An S corporation shareholder clearly has an incentive to minimize wage compensation. This creates a larger profit that is not subject to employment taxes. The S corporation profit is subject to only regular income tax payable by shareholders. Awareness of this situation by the IRS has resulted in greater attention of S corporations that pay less than “reasonable” compensation to active shareholders.
The IRS has authority to adjust S corporation income to reflect reasonable compensation. By declaring shareholder distributions as disguised compensation, the IRS may impose back payroll taxes along with penalties and interest. The IRS provides no definition of “reasonable” wages. However, its guidance suggests that reasonableness is determined by hours worked, duties performed, complexity and size of the business, corporate compensation policy, consistency of a shareholder’s salary history, economic conditions, and directly comparing the wages and distributions a shareholder receives. Therefore, the tradeoff for escaping self-employment tax on corporate profit is incurring payroll taxes on compensation that is fairly related to the value of services rendered.
A wise process for S corporations is documenting within the minutes of board of directors meetings the declared officer salaries along with description of services rendered. The minutes should address factors affecting the determination of reasonable compensation. For example, a low salary may be justifiable based upon debt service of the corporation, including start up loans provided by shareholders. Loans from shareholders should be documented and include interest calculated with repayment.
Another consideration with regard to compensation to shareholders is the effect on retirement plans. Because the profit of S corporations is not self-employment income, the IRS has ruled that such profit cannot be considered for purposes of funding qualified retirement plans. The only basis for retirement plan contributions is wage compensation.
The IRS is increasingly interested in S corporations making distributions to shareholders that exceed officer compensation. In addition, compensation that is far below the market wage in gaining IRS scrutiny. Comparison of shareholder compensation to salaries obtainable in arms-length negotiation is an important factor. Absent other factors, even documenting salary in corporate minutes does not make below-market compensation defensible.
Despite increased scrutiny by the IRS, entity classification as an S corporation continues to provide payroll tax minimization advantages. There is a possible balance between compensation and distributions that minimizes the tax burden of S corporation shareholders and deflects IRS scrutiny. It is achieved by considering the distinctive features of each business.