Will the IRS agree that your S Corp owner wages are reasonable?
Over the past five years, S Corporation compensation has become a key issue with the IRS. So much so that with the discussion of comprehensive tax reform, the IRS is considering making S Corporation profits subject to Self-Employment Tax, rather than just wages being subject to payroll taxes.
There are several current scenarios in which your distributions (draws) in addition to, or in place of, wages will be re-classified by the IRS to wages. If this happens, you will owe Social Security, Medicare, and Unemployment taxes on those reclassified amounts. And, you may face substantial penalties for failure to deposit payroll taxes and failure to file payroll returns. Not a pleasant outcome!
If you plan to argue that the distributions are loan repayments, you will need to show some proof. This would include a written agreement or promissory note, signed and dated. There should also be interest charged on the loan and paid to the shareholder on a regular basis, as well as a fixed repayment schedule. The company could even provide security for the loan. Not all of these must exist in order for the IRS to accept the payments as loan repayments, but written documentation of a valid lender –borrower relationship is vital to your case. Remember, loans are considered to be an unconditional obligation to repay, not a gift to be repaid whenever cash flow is readily available.
Another argument that has been diluted is the written agreement between the owner/shareholder and the company as to compensation. In many cases the shareholder is the only shareholder as well as the only director of the company. Since the shareholder is representing himself and the company, the agreement is not considered to be an arm’s length transaction; one in which both parties are working for their own interests and come to an agreement that is fair to both.
In reviewing recent court cases involving the IRS and S Corp owner/shareholders, there are several methods used to determine reasonable compensation. The IRS may use statistics from any number of professional organizations. A recent case used information from the Risk Management Association Annual Statement studies to compare the profit margin and percentage of compensation of officers/directors/owners to net sales. Also considered was the location and industry for the company. Tax Court has given its ruling after consideration of the shareholders’ experience in the industry, the scope of company operations (modest versus very profitable), whether the company’s success is due to a good market, good timing, or the personal services and expertise of the shareholder.
So how do you determine reasonable compensation for all that you do for your company? It is not as simple as sitting down and looking up a rate. Ideally, the process should go something like this. First, list all the services which you provide to your S Corp. and apportion your time among the services provided. Next, rate your expertise and experience for each service. Then, gather wage data on the compensation rate for the services you provide at your level of expertise. Finally, assemble the data, and calculate what reasonable compensation is for the services you provide to your company.
If you are like most shareholder/employees, you do so many different things which all take more time than you have available, so that this seems like an impossible task. And it will not be fun or easy to complete, but the rewards of not paying additional employment taxes or penalties can be worth the added time and effort.
The bottom line here seems to be that S corps, profitable or not, which transfer funds to shareholder/employees while paying no or small compensation may be in the sights of the IRS. So beware, S Corporation shareholder/employees!