Reasonable Compensation S Corp: Everything You Need to Know
What is reasonable compensation for S Corp shareholders? The IRS and S Corp business owners have long been at odds with how corporate officers should be compensated. 3 min read
What is reasonable compensation for S Corp shareholders? The IRS and S Corp business owners have long been at odds with how corporate officers should be compensated. The IRS scrutinizes shareholder-employees who are not "reasonably compensated." Shareholder-employees are corporate officers who contribute significantly the day-to-day business operations. The officers would rather receive compensation as an investor rather than get paid a worker's salary. Why? Because it affects their take-home revenue.
S Corporation Shareholder Compensation
If you are an S corporation shareholders, you may enjoy dividends. If you receive your profits as compensation, you are subject to payroll taxes. On the other hand, dividend distributions are not subject to taxes.
The IRS controls the number of dividends S Corps distributes to their shareholder-employees by requiring S corporation to adequately compensate these corporate officers like they would any other employee. Of course, this leads to court battles between the IRS and taxpayers as to what "fair" compensation is since their definition of what it is differs.
Usually, the S corporation wants lower salary and higher dividend distributions, while tax advisers must attempt in good faith to meet the IRS definition of fair compensation. However, until recently, the IRS did not provide reasonable compensation guidelines which meant the advisers' recommendations were really best guesses.
S Corporations and Employment Taxes
Since S corporations are pass-through entities, they typically distribute items like taxable income at the shareholder level. This means income is reported via shareholders and not the corporation itself.
Since the enactment of Rev. Rule 59-221, S corporations have enjoyed a great tax advantage: dividend distributions are not taxed as much as personal income. On the contrary, other entities like sole proprietorships, partnerships, and C corporation are subject to self-employment taxes without exception.
As Social Security and Medicare taxes rise, S corporations are even more attractive. Employers and employees split social security taxes. The employer pays 6.2% of the first $106,800 while the employee pays the additional 4.2%. Additional employers and employees split the 2.9% Medicare tax on all wages.
On the other hand, self-employed people pay the entire 10.4% Social Security which is taxed on the first $106,800, and they pay 2.9% Medicare tax on all self-employment income. With the rise of these tax obligation, shareholder-employees want to minimize their salary as much as possible in favor of dividend distribution. Why? Because they are not subject to either self-employment nor payroll tax.
Reasonable Compensation History: No Salary Taken
Because of this potential "loophole", the IRS has scrutinized shareholder-employee compensation and aggressively pursued perceived abuses by enacting Rev. Rul 74-44.
- This ruling forced an S corporation to put two of its shareholders that worked for the corporation on the payroll instead of receiving 100% of their compensation through distributions.
- Fifteen years later, the IRS further scrutinized an S corporation's action. Radtke was the sole shareholder and director of an S Corporation, a law firm. Instead of taking a compensation for the year in question, he withdrew $18,225 in dividends. The IRS argued that since Radtke was the sole significant employee, his dividend was salary. The district courts sided with the IRS.
- Although rare, there are instances where the shareholder victoriously defended their position. A district court ruled the IRS attempt to recharacterize the distributions as "arbitrary and capricious." While they held a significant position as president, they were not involved in the day-to-day operations. The court, therefore, ruled that based on their contributions (or lack thereof), dividends would not be treated as compensation. This ruling further set the precedence that a shareholder who minimally contributes their services does not need compensation.
What the Future Holds
S corporation reasonable compensation is still a controversial issue. As evidenced in the 2005 U.S. Treasury Inspector General Tax for Administration report (TIGTA), the IRS is still scrutinizing corporate distributions. They contend that shareholders owning more than 50% of an S corporation's stock should pay self-employment tax on their undistributed income.
The IRS has not stopped its scrutiny on shareholder compensation. There are some talks about lifting the cap on the amount of compensation subject to Social Security via payroll taxes. If something like that would happen, the cases of alleged S corp compensation abuse would rise.
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