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Determining Appropriate Owner Compensation in an S Corporation

The S corporation has been the dominant choice for small business operations in the United States for more than three decades, yet the IRS doesn’t offer solid guidance in an area of major concern: owner compensation. While the agency provides no “best practices” to follow, recent enforcement activity has substantially increased.

The last five years brought modifications to the “notice of acceptance of S corporation status.” The new response doesn’t merely confirm its acceptance of a subchapter S election; it also provides advice to the new S corporation and its owner/officers of their “tax obligations related to the payment of compensation to shareholder-employees of S corporations.” Specifically, we’re told, “when a shareholder-employee of an S corporation provides services to the S corporation, reasonable compensation needs to be paid.” 

The difficulty, of course, is the IRS determines what reasonable compensation should be based on dividends paid or other payments to working shareholders. Other facts and circumstances to be considered are the economic reality of owner compensation, including prevailing wages for peers inside and outside the business, wage and hour laws, hours of actual work, the balance between capital, non-owner employees and the shareholders in generating company income, and the documentation supporting the decisions of management. The bottom line driving this enforcement is the collection of appropriate employment taxes on the salaries in question.

The IRS clearly views employment taxes in partnerships, limited liability companies and S corporations differently. Partnership net earnings are subject to self-employment (SE) taxes for all but limited partners; thus, those partners pay their share of SE tax on their own income tax returns. The consensus seems to be that the “managers” of an LLC are subject to the SE tax, while those members in a passive role generally aren’t. Universal agreement exists that the share of S corporation income qualifying as a “pass-through” to the shareholder’s K-1 isn’t subject to self-employment tax. The challenge comes in the determination of how much of the corporate income should be designated as owner’s compensation, on which FICA, Medicare and FUTA tax is assessed.

The corporate board must find the delicate balance between paying enough, but not too much, salary to shareholder-employees, to minimize the employment taxes on those officers. Since Revenue Rulings and case law are heavily weighted in favor of the IRS, it’s only natural this issue holds high priority in an agent’s audit agenda. The issue of unreasonably low salary payments to S corporation shareholder-employees has long been a chief audit concern of the IRS.

Consider the risk of not declaring a reasonable salary against the savings of these payroll taxes. Should the IRS reassign distributions or shareholder loan payments as compensation, the basis of reclassification will likely be considered the net salary. FICA and Medicare tax will be added to this amount, and employer payroll taxes assessed on top of that. Further, potential penalties exist for failure to file payroll returns, deposit taxes on time (plus interest for late payment), and withhold on the undeclared salary. These penalties and interest assessments could easily add 50 percent to the underpaid taxes.

If you need assistance in making a compensation policy that will put you and your S corporation in a safer position, Patrick & Robinson CPAs can help you make that determination and assist with all aspects of your payroll processing and filing. Contact us at Office@CPAsite.com or 904-396-5400 today.

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