When our clients are faced with making business formation decisions, we often advise they go the S corporation route. An S corporation serves as a pass-through entity much like a partnership or LLC so that income and losses are ultimately reported on the shareholder’s personal tax return. While sole proprietors, partners and LLC members are subject to self-employment (SE) tax on their business earnings, S corporations’ undistributed earnings are not (Revenue Ruling 59-221).
S corporation owners are however responsible for paying 15.3% employment taxes due on wages paid to themselves (12.4% Social Security and 2.9% Medicare). In order to avoid paying such high employment tax rates, owners often try to pay themselves as little as possible. Some have even attempted to take no salary from their corporations and have opted instead for cash distributions which are neither taxable to the shareholder nor subject to SE tax. The IRS has nixed this scheme in the past stating that owners of S corporations must take a “reasonable salary”. For years this has made our job difficult as we work with our clients to determine what this obscure “reasonableness” actually means. We found a wonderful (and informative) Forbes article earlier this month on Tax Geek Tuesday . This article outlines 3 court cases – JD & Associates , Watson , and McAlary which each shed a little more guidance on how the IRS and courts have determined the reasonableness of an officer’s compensation.
After the JD & Associates case, the IRS issued Fact Sheet 2008-25 in which they laid out 9 factors to consider in determining shareholder compensation:
1. Training and experience;
2. Duties and responsibilities;
3. Time and effort devoted to the business;
4. Dividend history;
5. Payments to non-shareholder employee;
6. Timing and manner of paying bonuses to key people;
7. What comparable businesses pay for similar services;
8. Compensation agreements;
9. The use of a formula to determine compensation (percentage of gross or net income)
While the IRS scrutinizes these payments to shareholders very carefully it is advisable that you do the same to avoid attracting any unwanted attention from it’s agents.
Stephen Osborne, CPA