WHAT IS AN S CORPORATION?
An S corporation is a regular corporation that has elected to be taxed and an S corp. One primary reason people choose the S election is to avoid double taxation. Simply put, a regular corporation, also known as a C corporation per this article, is taxed at the corporate level and again when the already taxed dollars are distributed as dividends to the corporate shareholders. Conversely, income of an S corporation is not taxed at the corporate level but instead, the income passes directly through to the shareholder’s personal tax return where it is taxed for the first time.
ONE OF THE MAJOR REASONS SOME BUSINESS OWNERS CHOOSE THE S ELECTION
A relatively significant number of small business owners set themselves up as S corporations. One of the biggest reasons for their decision is that having an S Corporation can reduce the amount of tax a business owner pays on their personal tax return. However, this has become a huge audit red flag for the IRS. An S corporation owner who actively works in the business is both an employee and a shareholder of the business. This dual role (employee and shareholder) allows for lower taxes because of the elimination of Social Security and Medicare taxes on the distribution of earnings and profits paid to the shareholder by the corporation. Hence, to the extent a shareholder receives distributions rather than a salary; the shareholder/employee can save big money by not paying payroll taxes.
WHO DECIDES THE SALARY OF EMPLOYEES
The directors and officers of an S corporation are the ones to decide how much to pay the employees. Often time’s S corporations are owned by one individual, so that person has complete discretion to decide how much salary to pay themselves. By law, an S corporation is required to pay reasonable wages (subject to employment taxes) to its shareholder-employee before paying distributions (not subject to employment taxes) to its shareholder-employee.
Sadly, many S corporation owners have decided not to pay themselves any employee compensation at all, and as a result, have not paid any payroll taxes. In the year 2000, the IRS Inspector General found that about 440,000 single-shareholder S corporations paid little or no salary to their owners. This cost the government millions in lost payroll taxes which did not make them happy. Consequently, the IRS stepped up its audit of thousands of S corporations that were found to have grossly underpaid the salary of their employee-shareholders, or in some cases, paid no salaries at all.
S CORPORATION PAYROLL AUDIT
If after an audit or examination the IRS determines that an S corporation owner has tried to evade paying payroll taxes by disguising employee salaries as shareholder distributions, they can recharacterize the payments as salary and require the business to pay employment taxes and payroll tax penalties on the recategorized salary. Penalties can run in upwards of 100% of the payroll tax amount plus additional negligence penalties.
For example, in the case Watson v. United States, (DC IA 05/27/2010) 105 AFTR 2d 2010-908, and I quote, “In a recent district court case in which IRS claimed that a portion of the dividend distributed by an S corporation to its sole owner should be recharacterized as wages subject to employment taxes, the court rejected the corporation’s assertion that IRS could not compel the corporation to pay a higher salary to the owner. Accordingly, the court would not order IRS to refund employment taxes paid by the corporation after IRS made the assessment. Rather, it allowed the case to proceed” end quote.
In the case above, the S corporation paid its sole owner a salary of $24,000 and a distribution of about $220,000 in 2003. The IRS recharacterized approximately $175,000 of the distributed amount from a distribution to employment salary and required payroll taxes be paid on the recharacterized distribution. The court upheld the IRS decision.
WHAT IS CONSIDERED A REASONABLE SALARY?
So, as a general rule, it is prudent that an S corporation pays its shareholder-employees a reasonable salary. The question then becomes, what is considered “reasonable” according to IRS standards? The IRS does not have precise guidelines when determining what a reasonable salary is. Instead, they make their decision on a case-by-case basis. They do, however, have a list of factors they consider when trying to make a determination of reasonableness. Among the factors are:
- What duties does the employee perform
- How much of the business (the volume of business) does the employee handle
- What type of work is involved and how much responsibility does the employee have
- How complex is the business
- How much time and effort does the employee devote to the business
- Use of some sort of a formula to determine compensation
- What is the cost of living in the locality the employee resides
- How able is the employee to perform the job and what are his/her achievements
- What the S corporation paid the employee compared to the gross and net income of the business, as well as the amount of distributions made to the shareholders
- What is the company’s policy regarding pay for all employees, and
- What is the payment history for each employee?
After taking all the above circumstances into consideration, the IRS will then establish what they consider a range of reasonable salaries, from low to high. If the S corporation paid its shareholder-employee an amount between the established range, none of the distributed income would likely be recharacterized. On the other hand, if the S corporation did not pay its shareholder any salary at all, or an amount below the established reasonable range, all distributions paid to the shareholder-employee up to a reasonable salary range will be recharacterized as employee salary subject to payroll taxes.
Consult with your CPA or accountant if you are not sure what constitutes a “reasonable salary.”
Have a great week!!!
Desarie Anderson, CPA, EA
Anderson Accounting, LLC