The single most important tax attribute for S Corporation owners is that their share of the entity’s net income is not considered self-employment earning and therefore is not subject to self-employment taxes. In contrast, sole proprietors, LLC members and general partners’ net earnings are subject to self-employment taxes at a 2017 current rate of 15.3% and an additional .09% for high-income earner. As a result, S Corporation owners often reduce their wage compensation and increase their distributions to manage their tax burden.
However, S Corporations are required to pay reasonable compensation to owners, considered shareholder-employees, for the efforts they contribute to conducting their trade or business. Any method of payment from the corporation to a shareholder-employee must be treated as wages to the extent such amounts are reasonable compensation. In determining reasonable compensation, the IRS evaluates many factors:
- A primary consideration in determining reasonable compensation is the source of the gross receipts of the S Corporation. Are the gross receipts generated by direct services of the shareholder? If so, most of the profit distributions should be allocated as wage compensation. A lower percentage of distributions are subject to wage compensation if the gross receipts are derived from services of non-shareholder employees or capital and equipment investment.
- Factors directly tied to evaluating reasonable compensation of the shareholder-employee are his or her training, education and experience, their duties and responsibilities and the time devoted to the business. The greater role these attributes play in earning the gross receipts of the corporation, the greater the amount of distribution is required to be deemed wage compensation.
- Some additional factors in determining reasonable compensation are comparable business pay for similar services, compensation agreements, payments to non-shareholder employees, dividend history, timing and manner of paying bonuses to key employees, prevailing economic conditions, the size and complexity of the business and the use of compensation formulas.
The IRS has had a great deal of success in litigating in the courts what the feel is reasonable compensation for a shareholder-employee. They have the authority to reclassify distributions or other payments to the shareholder-employee, including the repayment of loans as compensation if it deems the overall compensation unreasonable or inadequate. A reclassification of distributions to compensation as a result of an audit cannot only increase the payroll tax liability but will also subject the corporation to interest and penalty.
Active shareholders who are employees should be consistent in their determination of reasonable compensation, should maintain written logs of their work, minimize loans from the company and pay themselves reasonable compensation. The determination of reasonable compensation is very fact sensitive and unique to each entity. As of 2016, the IRS is actively tracking shareholder-employee compensation relative to distributions within S Corporation returns. Contact us to review your determination of reasonable compensation and reduce your risk of an IRS audit.