Besides its single level of taxation as a passthrough entity, an advantage of an S corporation over a C corporation is that a shareholder’s share of the corporation’s net income is not considered self-employment earnings and therefore is not subject to self-employment tax (13.3% in 2011 and 2012). This treatment is in contrast to that of a general partner, LLC member, or sole proprietor, for whom net earnings from self-employment include any trade or business income and a partner’s distributive share of income from a trade or business carried on by the partnership (Sec. 1402(a)).
However, if the S corporation shareholder provides services to the S corporation, he or she must receive an adequate or reasonable amount of compensation for these services. The S corporation may deduct the compensation expense and must pay the employer share of employment taxes: 6.2% Social Security tax and 1.45% Medicare tax. The shareholder-employee is responsible for 4.2% Social Security tax (in 2011 and 2012) and 1.45% Medicare tax. The S corporation is also responsible for Federal Unemployment Tax Act (FUTA) taxes. Minimizing these taxes provides an incentive to keep the S corporation shareholder’s wages low and to characterize most of the passthrough income as distributions.
The U.S. Government Accountability Office reported in 2009 on employment tax noncompliance among S corporation shareholders. The IRS has been pursuing this perceived abuse of inadequate compensation in favor of dividend distributions to shareholder-employees and has won a number of cases. (See, for example, Watson, No. 11-1589 (8th Cir. 2/21/12), described in Tax Matters, page 62.)
The IRS has the authority to reclassify dividends, distributions, or payments to the shareholder-employee, including loan repayments, as compensation if it deems compensation inadequate or unreasonable. The courts have held that the question of reasonable compensation is one of fact, determined on a case-by-case basis. The IRS has posted on its website (tinyurl.com/7kp3yrf) three major sources of gross receipts it will consider when determining reasonable compensation: the services provided by the shareholder, the services of nonshareholder employees, and the capital and equipment of the corporation.
IRS fact sheet FS-2008-25, Wage Compensation for S Corporation Officers, lists the following factors in determining reasonable compensation: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to nonshareholder employees, timing and manner of paying bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and the use of a formula to determine compensation. Sources of information on comparable compensation for services include the U.S. Department of Labor’s Bureau of Labor Statistics, employment agencies, and a market analysis. The key in defending a claimed compensation amount is to document all research to support the amount.
Shareholders who are officers of a corporation who do not perform any services or perform only minor services in that capacity and who do not receive or are not entitled to receive direct or indirect compensation are not considered employees of the corporation. Thus, since most shareholder-officers of closely held corporations do provide more than minor services to the corporation, they most likely are considered employees. If a shareholder is an officer who is considered an employee, Section 530 of the Revenue Act of 1978, P.L. 95-600, does not apply as a safe harbor for recharacterizing the shareholder’s compensation because, under Sec. 3121(d)(1), corporate officers are statutory employees (see Joseph M. Grey, P.C., 119 T.C. 121).
The S corporation entity form provides planning opportunities to avoid payroll taxes or self-employment taxes on distributions that are instead a return on capital and assets. With the increase in Medicare tax of an additional 0.9% for high-wage earners scheduled to begin in 2013, this may represent a larger opportunity. The key in defending against a possible audit and recharacterization of dividends is to document all research and analysis of the determination of the shareholder-employee salary.
By Debra M. Johnson, CPA, J.D., (firstname.lastname@example.org) associate professor, Montana State University–Billings in Billings, Mont.
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