Many small businesses elect to be taxed as an S corporation rather than as a partnership or a disregarded entity in order to take advantage of the tax rules involving distributions from S corporations. However, if the shareholders of an S corporation are also employees, they must be paid through salary reported on a W-2 as well. Since employment taxes are assessed on W-2 salary but not on shareholder distributions, and since S corporations are becoming more and more popular, the IRS is auditing more and more S corporations for underpaying their shareholders’ salaries. Here are a few tips to help avoid potential “reasonable compensation” audits of shareholders’ salaries:
Understand the methods that the IRS and the courts use to determine reasonable compensation. Although S corporation shareholder reasonable compensation disputes are relatively new, the IRS and the courts have established a couple of specific methods to evaluate what reasonable compensation in a given situation. The first method is known as the multifactor approach. It involves weighing a variety of factors, including the source of gross revenues (the more revenue that is generated by non-shareholder employees or equipment, the more profit distributions can be taken by the shareholder(s)), a comparison of compensation to employees at similar businesses providing similar services, the shareholder’s qualifications and experience as an employee, and the compensation paid to similar non-shareholder employees, among other items. Since this method involves weighing a variety of factors against one another, it does not directly lead to a dollar amount of “reasonable compensation”. The second method, the independent investor test, involves considering the shareholder-employee as two separate people – a shareholder and an employee. After all employees, including the “split” employee, are compensated, the return on capital provided to the shareholder is compared to returns from similar companies. The more similar the returns are, the more likely the shareholder’s compensation as an employee is to be reasonable.
Be aware of compensation comparability data. Since the IRS and the courts lean heavily on the comparability of shareholders’ compensation to similar employees’ compensation, S corporations should consider researching and possibly using this data to help set shareholder-employees’ compensation. This data can be found from a variety of sources, but care should be taken to focus on compensation by companies in similar industries and similar geographic areas to employees in similar positions. However, the value of a given shareholder-employee relative to the most comparable employees found should also be considered. Part-time or ineffective shareholder-employees can often be paid reasonably paid below-average wages, while high performers may require more compensation than average.
Report the correct percentage of time devoted to the business. The IRS requires S corporations with gross receipts of $500,000 or more to file Form 1125-E, Compensation of Officers, with its 1120S. Form 1125-E requires the S corporation to report the name, social security number, compensation, stock ownership percentage, and percentage of time spent on the business for each officer. This last item, percentage of time spent on the business, is the most relevant for evaluating the reasonableness of the shareholder-employees’ compensation. The greater the percentage of time spent on the business, the more compensation the IRS will expect. This percentage can be quite variable from year to year for a variety of reasons, including health issues, family changes, and involvement in other business ventures. As a result, this percentage of time spent figure should be reviewed carefully each year.
Avoid having the S corporation loan money to a shareholder. Shareholder loans are separately reported on an S corporation’s tax return balance sheet, so the IRS can easily take a close look at them. The loans remaining unpaid over the course of multiple tax returns and the lack of a bona fide note reflecting the loan are two warning signs that may cause the IRS to consider deeming the loan disguised compensation.
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