Compensation for S Corporation Shareholders: How Much is Enough
By David Donnelly, Senior Manager, Tax & Business Services
Many pass-through businesses operate as “S” corporations. This is where a business incorporates under a state’s law and then files an election with the Internal Revenue Service stating that the income, deductions, and certain other items will not be taxed on the entity’s tax return but rather “passed through” and reported on the shareholders’ personal tax returns (IRS Form 1040). This pass-through treatment usually applies for state purposes as well.
Shareholders who perform services for the corporation are entitled to compensation, typically in the form of wages. Payment of wages to these individuals requires Social Security and Medicare taxes to be withheld from salary. A shareholder could also take a distribution check to avoid these withholdings.
However, the instructions to Form 1120S state that “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.” So what is “reasonable compensation”?
Individuals who are partners in a partnership or operate a sole proprietorship generally pay self-employment (Social Security) taxes on all of their proportionate share of income from the business. An “S” corporation shareholder only pays Social Security tax on wages paid by the corporation. If little or no wages are paid to a shareholder, very little, if any, Social Security taxes are paid to the government. As a result, the shareholder will receive minimal Social Security benefits upon retirement.
Some “S” corporation shareholders, while aware of the above, still “play the audit lottery” by taking minimal salaries in favor of distributions. This is done to save on payroll taxes while increasing precious cash flow. This is a big mistake!
During an audit of an “S” corporation return, an IRS agent will frequently look at both the wages and distributions paid to a shareholder. The reason for this is pretty basic. If the shareholder is taking little to no salary and receiving much larger distributions, the government is not receiving Social Security taxes. The IRS may scrutinize such a scenario.
The IRS has the ability to re-characterize distributions as salary and impose payroll taxes, interest, and possibly non-deductible penalties. Penalties for late filing, late payment, and late deposit of taxes can also be assessed.
According to the IRS, the definition of “reasonable compensation” is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
Some of the elements that are considered to determine reasonable compensation include:
- Training and experience of the individual.
- 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 – if necessary, have a compensation study done.
- Compensation agreements.
- The use of a formula to determine compensation.
- Replacement Cost – If the shareholder were not performing services for the business and management had to hire an outsider to do the same thing, what would it cost? It is not reasonable to pay the shareholder/employee $10,000 per year, for example, when a similar position on the outside would pay $150,000.
- Fair Market Value – What is the value of that person’s services?
- Loans to Shareholders – Similar to distributions. A tough argument to make on an examination is that the company does not have enough cash to make payroll but does have the funds to “lend” to the shareholder. Pay a reasonable salary, if loans are going to be made.
- Zero compensation and large distributions.
- Low salary vs. large distributions.
- Ratios that are out of line such as:
- Sales vs. compensation.
- Distributions vs. compensation.
- Profit vs. compensation.
When a shareholder is taking large distributions and minimal or no salary, s/he could be shortchanging him or herself in the long-run in terms of future Social Security benefits. The general rule is that the greater the wages subject to Social Security taxes (up to certain limits), the greater an individual’s ultimate Social Security benefits. Minimizing salary could reduce the benefits you will receive over your lifetime.
Shareholder compensation deserves careful review. If structured properly, salaries paid to shareholders should be sustained. If not done properly, significant balances can be assessed on audit for tax, interest, and non-deductible penalties.