The cornerstone of the American economy is the small business. There are millions of small businesses providing goods and services to the country.
According to IRS estimates, over 5 million of those small businesses have identified themselves as an S corps.
What does that mean for the business? How is officer compensation in an S corp better for shareholders?
As a tax entity, the S corp status holds some real advantages for officers. Yet, it also holds some risks too when you consider reasonable compensation.
Read on to learn more about the role of reasonable compensation in an S corp and why it’s important for tax considerations.
What Is an S Corp?
Many people think of an S corp as one type of business model. In fact, an S corp is a type of tax entity a business could elect to use. In the S corp model, the corporation elects to pass income, losses, deductions, and credits to shareholders for tax purposes.
So, instead of the business paying the tax on the income, it’s passed on to a company individual who pays their tax rate as an individual. This saves the company and can be quite lucrative for the shareholders too. The shareholders can take dividends or end-of-the-year bonuses that are not taxed like regular income after taking reasonable compensation for the work they do for the company.
The question usually becomes what amount is considered reasonable compensation. More on this later.
How can a company become an S corporation? The IRS uses Form 2553 to qualify to become an S corp. Here are some of the criteria a company must have to qualify”
- Be a US company
- Have allowable shareholder
- Could be individuals, certain trusts, and estates
- Cannot be partnerships, corporations, or non-resident alien shareholders
- 100 shareholders or less
- Have only one class of stock
There are some companies, by the nature of what they do, that is ineligible. This might include an insurance company, a financial institution, or a company that is domestic that does international sales.
How Does an S Corp Compare to Other Business Models?
Small businesses as they get started must decide on the structure of their business. The format of their business will impact their day-to-day operations, taxes, and even the assets of shareholders.
Some common business structures include:
- Sole proprietorship
- Limited liability company
- C corporation
A sole proprietorship means the business owner is the sole proprietor. This means they don’t separate their business dealings from their personal ones. The business assets get combined as part of their personal assets.
Often a low-risk business or a business owner who wants to test the waters of their business will start as a sole proprietorship.
Partnerships are the simplest business structure when you have two or more people involved in the business. The most common types of partnerships have limited liability partnerships and limited partnerships.
In a limited liability partnership, all the partners share the limited liability. It provides a shield of protection for the actions of the other partners. One partner wouldn’t be held responsible for the business debt created by another partner.
In a limited liability, one partner has unlimited liability, while the others share limited liability. Typically, this model would get used if you have one partner actively involved in the business while the others are not.
A limited liability company provides liability and asset protection for the shareholders. If the business was in trouble, personal assets like a car and house would get protected from business debts.
When there are profits or losses, they can get moved through the shareholder’s personal assets without needing to pay corporate taxes. An LLC member is considered self-employed and must self-employment taxes for social security and medicare.
C Corp and S Corp
A corp is a business structure where the business and personal assets are completely separate. C corp provides the best liability protection for a shareholder. Unlike the previous structures, a C corp pays income tax on its profit. Sometimes that means it’s taxed twice, once as a business and then again when dividends are paid out.
C corps have a completely separate existence from their shareholders.
An S corp is different from a C corp as it works to avoid the double taxation that happens for a C corp. A S corp can allow for some profits and losses to pass to the owners’ personal assets, therefore avoiding the corporate taxing.
Many experts consider an S corp more of a tax structure than a business structure, especially compared to some of the other models.
There are many similarities between an LLC and an S corp, yet the key difference is the taxes. In an LLC, a shareholder or owner is taxed once and often twice. In an S corp, they would only be taxed one time.
Understanding the IRS Term Reasonable Compensation
The key to understanding an S corporation is reasonable compensation. An S corporation can payout dividends to its shareholders at the end of the year. These dividends are not taxed the same way they would be as wages.
Many prefer the S corp model because they can avoid paying those taxes by taking dividends or bonuses at the end. The IRS then started to require shareholders to take a reasonable compensation that can be taxed. There are many guidelines for reasonable compensation, but it can be a tricky thing for S corporations and will lead to an audit if not done carefully.
What’s Considered Reasonable?
Reasonable compensation for an S corp becomes the debate when becoming one. What is reasonable? Certainly, for the shareholders, it’s most desirable to want as small of a compensation package as possible. This allows them to pay as little in payroll tax as possible.
When they take the profits as dividends they can then avoid those taxes.
The IRS has become increasingly particular about what they consider reasonable and uses several benchmarks to guide S corp shareholders about reasonable compensation.
Ultimately, the IRS believes the reasonable compensation should work out to about one-third of the net profits of an S corp. Convincing shareholders to take that amount in taxable compensation often becomes the challenge.
Factors for Reasonable Compensation
The IRS has released information about how to work towards reasonable compensation. The fact sheet says to take these things into consideration when deciding on reasonable compensation for a shareholder:
- Responsibilities and duties in the company
- Level of experience
- How much time do they devote to the business?
- History of what they have been paid in dividends
- What amount of pay do non-shareholder employees receive?
- What do comparable businesses pay for the same services?
- Compensation agreements
Interestingly, the IRS might use this list when evaluating C corp shareholders’ salaries, often saying they make too much. Conversely, the IRS might use this list to say an S corp employee isn’t being paid enough.
The IRS will look to see if the shareholder is making what they’d likely be making if they worked in the same capacity someplace else. Not paying enough in reasonable compensation will likely get the IRS’s attention and open an S corp up for an audit.
Key Cases Related to Reasonable Compensation
Becoming an S Corp has been a way for many owners of companies to avoid paying those higher payroll taxes with little guidance from the IRS. As the IRS started to pay closer attention to what was happening with S corp salaries, they still provided little guidance on their considerations for reasonable compensation.
Recently though, there have been several legal cases that have provided some benchmarks for reasonable compensation.
Watson v. Commissioner
In the case Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012), Watson was a sole owner of a lucrative accounting firm that grossed around $3 million in profits. As the courts studied Watson’s background they learned he was a Certified Public Accountant with extensive experience and several advanced degrees.
Watson took only $24,000 in salary. The IRS asserted that he couldn’t sustain his lifestyle on that wage and the dividends he was taking (not taxed) were actually payment for services and therefore should be considered wages.
When the court ruled, his dividends were reclassified as wages by the IRS. As such, he was assessed additional taxes, penalties, and interest.
JD & Associates, Ltd. v. United States
Another key case involving an accountant, Dahl, JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (District Court, North Dakota, 2006), the IRS went after Dahl because of his low salary.
He was the sole owner of the accounting firm. The IRS hired valuation experts to look at the work Dahl did compared to others in similar roles. His salary compared to others created a strong case for the IRS.
Then they look at what Dahl paid other employees in his firm, including support staff. He actually paid himself less than his clerical staff.
The court ruled against Dahl stating his dividends were again salary. He couldn’t provide the services to the company and actually made less money than the people who worked for him in support of what he did.
Legal Threshold for Reasonable Compensation
These two cases and several others provided a legal threshold for the IRS to begin to question the salaries of S corp shareholders with more scrutiny.
While there are still not strict rules written for the salaries of S corp shareholders, the guidelines should be noted with more care.
Sure, an S corp provides a way for shareholders to avoid the double taxation of a C corp, in the eyes of the IRS it doesn’t mean you can avoid paying those taxes either.
When deciding on the salary that will be taxed, shareholders of a company should look closely at those guideline questions provided by the IRS to determine their salary.
Tips to Avoid an S Corp Audit
So, if you opt to classify as an S corp, what can you do to avoid the ire of the IRS and steer clear of an audit? Let’s take a closer look at some things you can do as a business to avoid an audit.
Identify Officers of the Company
One of the first things to do is to identify the officers of the company. In some cases, a company’s officer may not be a shareholder. In other cases, an officer may be a passive member of the company acting as an officer, but not actively working in the company.
The IRS will want to understand the role of the officers.
All Shareholders to Take Reasonable Compensation
It’s clear that often classifying as an S corp is motivation to avoid paying those payroll taxes. Yet, the shareholders need to consider realistically what is reasonable compensation.
All shareholders should be accountable to take a taxable salary that fits under the purview of reasonable compensation.
Consistent Policy for Shareholders
As a company, it’s important to take a consistent stand on the role and compensation for a shareholder. When a shareholder does their personal income tax, their level of involvement in the company, passive or level of activity, should be consistent with what the company is reporting.
Clearly Identify Percentage of Time Dedicated to Business
One of the most obvious considerations used by the IRS is the amount of time or percentage of time the shareholder dedicates to the business.
This percentage of time spent in a working role for the company should be consistent in their reasonable compensation.
Use Correct Business Activity Code
The IRS will expect a business to use the correct code to classify themselves. These codes can change over time depending on the nature of the business. The instructions to Form 1120S discuss the number of trades or business involved.
If there are multiple lines of business, shareholders will need to designate their role and time spent in each line of business and the correct business activity code needs to be used.
Officer Compensation S Corp Tax Entity
There are many reasons a business may want to designate as an S corp. Officer compensation in an S corp can get adjusted to lighten the tax burden. Yet, shareholders need to be cautious to take the appropriate reasonable compensation that gets taxed to avoid the attention of the IRS.
If you have questions about becoming an S corp or need the assistance of one of our tax attorneys with the IRS, we can help. Contact us today so our team can help you with your tax needs.