The legal entity chosen by a business will define the legal and tax compliance requirements of the business. That being said, “S-Corporations” are very popular in the small business community. An “S-Corporation” is a corporation that has made a tax election to be treated for tax purposes as a flow-thru entity similar to that of a partnership. However, there is one HUGE difference between an S-Corporations & Partnership with regards to flow-thru income. The flow-thru income from a partnership is subject to self-employment taxes whereas the flow-thru income from an S-Corporation is not subject to self-employment taxes. Let me explain, a partner in a partnership cannot also be an employee in the same business (see rev. rul. 69-184) A partner that performs services for the partnership is paid via a “guaranteed payment” in lieu of salary all the income of the partnership (guaranteed payment & flow-thru income) is subject to self-employment taxes. Unlike a partnership, the owners of an S-Corporation can be both a shareholder and an employee in the same businesses. Any shareholder that works for the business will be paid wages or salary which is subject to payroll taxes. However, the income of the S-Corporation that flow-thru to the owner is NOT subject to self-employment taxes. Given that this flow-thru income is not subject to self-employment taxes the IRS requires s-corporation shareholder-employees to take a “reasonable salary”.
In Practice – Owners of S-Corporations sometimes find themselves in hot water with the IRS for not taking enough salary and in some cases not taking any salary. S-Corporation employee-shareholders would rather be paid from company profits via distributions than payroll to avoid or minimize payroll taxes.
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What is Reasonable Salary?
Reasonable compensation [or salary] is the amount that would normally be paid for similar services by a similar employer under similar circumstances -Reg. Sec 1.1162-7(b)(3).
IRS Guidance S-Corporation Reasonable Salary
From the IRS website page: S Corporation Compensation and Medical Insurance Issues
“S-corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee offers to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly”
What the IRS is saying: The IRS has the power to reclassify distributions to wages subject to payroll taxes (if this happens taxpayer will also be hit with penalty and interest) if the IRS does not believe taxpayer took a “reasonable salary.” However, the IRS cannot force taxpayers to take a salary i.e. if a shareholder performing services took little to no salary but did not take any money out via distributions the IRS would have nothing to reclassify to wages.
“The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation. As such, we need to look to the source of the S corporation’s gross receipts.
The three major sources are:
- Services of shareholder,
- Services of non-shareholder employees, or
- Capital and equipment.
If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee’s personal services and it is reasonable that the shareholder would receive distributions along with compensations.
On the other hand, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation”.
What the IRS is saying: If you are in a service industry or business (i.e. accountant or lawyer) and do not have any other employees then most if not all the money paid to shareholder-employee should be in the form of salary and not distributions.
The IRS webpage further lists some factors that may be considered in determining reasonable compensation:
“Some factors in determining reasonable compensation:
- 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”
How are S-Corporations determining Reasonable Salary?
Method 1: Taxpayer Research
This method involves the taxpayer turning to the internet and websites that regularly publish fair-market value wages based on location. Also, the taxpayer should look to similar business and compare the industry standards, and benchmarks. Once the taxpayer has done the necessary research and is confident about calculating a reasonable compensation number; the taxpayer should document research and calculations and keep with other tax return records.
Method 2: Purchase a Reasonable Compensation Report
This method is similar to the taxpayer research method but instead, the taxpayer is using a service that is in the business of calculating reasonable compensation. These companies will actually calculate reasonable compensation based on numerous factors and create a report that is literally a defensible position to an IRS challenge. I like this method because the taxpayer now has substantial documentation if ever challenged by the IRS. It is important to understand IRS auditors are not out to hurt taxpayers; auditors are simply doing their job which entails working through an audit checklist. If you hand the auditor a well-documented reasonable compensation report they can check the box and move on with the audit.
Method 3: The 60-40 Method
I HATE this method. I only mention it here because it is sometimes used in practice. Under a 60-40 approach, 60% of the money paid to the shareholder-employee is salary and the other 40% of the money paid to the shareholder-employee are distributions.
Example – An S-Corporation with a single owner that actively works in the business (shareholder-employee) has $100,000 from operations to pay-out to the owner. Using the 60-40 method; $60,000 will be paid via wages and $40,000 paid out via distributions.
Why do I hate this method? Employee wages should never jump up or down depending on the performance of the business. I think most people will agree that employees are paid for their time which has nothing to do with the performance of the business. Stated another way, employees are selling their labor in units of time and employers are purchasing labor in units of time which is not related to the performance of the business. Also, wages based solely on the performance of the business will be very volatile.
FYI- Telling an IRS auditor that you calculated reasonable salary based on the 60-40 method is the equivalent of saying you have no documentation.
Taxpayers are left to take a defensible position and define “reasonable” for themselves. The problem is what is reasonable in the eyes of the taxpayer may not be reasonable in the eyes of the IRS.
If you liked this article you may also like these related articles:
- Entity Selection: S-Corporation or LLC
- Never Hold Real Estate in a Corporation
- Should a New York Business be a Delaware LLC?
Disclaimer: This article is offered for general informational and educational purposes only and not intended to be tax or legal advice.
Peter Alizio is a CPA and Tax Attorney. When he is not solving IRS and NYS tax problems he likes football and playing amateur chef. He also enjoys meeting new people, preferably over coffee, whiskey or cigars.