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IRS to Increase Focus on Reasonable Compensation for S-Corporation Shareholders

by Lora Ament
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A Subchapter S corporation is a small corporation that has elected to be taxed as a pass-through entity whereby income and losses flow through the corporation to the owner’s personal income tax return.    An S corporation shareholder/owner who works in the business as an officer, such as president, chief financial officer, etc. is considered an employee so the shareholder’s income is divided between their share of the profits and his income as an employee.  The business must withhold FICA taxes and federal income taxes from employee pay and the business must also pay those FICA taxes along with other employment taxes.  Many S corporations try to avoid paying these taxes by classifying more of the owner’s income as a distribution rather than employee compensation.

S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.  The instructions to the Form 1120S, US Income Tax Return for an S Corporation, state “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”.  This leads to the question “How is a reasonable salary determined?”

In order to establish a fair and reasonable salary, S corporation shareholders should consider how they would determine the salary of an employee, including qualifications, job responsibilities, amount of time devoted to the business and what comparable businesses are currently paying for similar services.  There are other factors that can play a role in determining the reasonable salary for shareholders as well, such as the type of business, years the business has been operating, other employees generating profit for the business and capital invested in the business.  It is important to establish and document how the determination was made that shareholder salaries are reasonable in case of an IRS audit.  From the IRS’ viewpoint, if too little salary is paid to shareholders, then the distributions are higher, and the IRS could be missing out on potential payroll taxes.

Beginning in 2018, justification for S corporation shareholders to have a reasonable salary is more important than ever because of the Section 199A Qualified Business Income Deduction.  In general, pass-through entity owners can receive a deduction of up to 20% on their share of the business profits but will not be eligible to take this deduction on the wages the shareholder receives from the S corporation.  Because of this new deduction, S corporation shareholders have an even greater incentive to classify more of the profits as a distribution rather than employee compensation.  However, it also gives the IRS a larger incentive to question the reasonable compensation requirement.

Only in circumstances in which shareholders of an S corporation do not perform any services, or perform only minor services, and who do not receive compensation, are not considered employees of the corporation.  However, since most shareholder-employees of S corporations do provide more than minor services to the corporation, they do, in fact, act in an employee capacity.  It is, therefore, advisable for them to receive some salary from the S corporation even if it is at the low end of the reasonableness scale.

Although many S corporations are small businesses, the tax rules that apply to compensation of their shareholder-employees are far from simple.  Since the incentive to underestimate S corporation shareholders’ compensation in the form of wages is greater than in previous years, it is likely that the IRS will examine S corporations and their shareholders more frequently and in more detail. If the IRS reclassifies shareholder distributions as wages, payroll taxes must be paid for those wages, and there will likely be substantial penalties for not filing and paying payroll taxes.

S corporations need proactive and comprehensive advice from their CPAs to ensure compliance with the reasonable compensation rules to ensure compliance, minimize taxes and avoid red flags which may trigger an IRS audit.  Contact us at Louis Plung & Company LLP so that our experts can help advise with your particular business situation.

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