Tom Talks Taxes - July 7, 2023
Reasonable compensation and S corporations: an overview
This is the first in a series of articles on reasonable compensation for corporations.
Reasonable compensation is an essential issue for tax professionals who work with business owners: it is both a compliance and a planning consideration. Both S corporations and C corporations must generally pay reasonable wage compensation to their shareholders for services provided to the corporation. Each corporation type has different reasonable compensation issues and opportunities; this article series will cover S corporations first, followed by C corporations.
An S corporation shareholder/employee is incentivized to shift income from wage compensation to pass-through income to reduce payroll taxes. For the S corporation, the determination is “Is the salary adequate?”
The IRS position in Rev. Rul. 74-44, which is supported by various court decisions, is that S corporation distributions paid in lieu of reasonable compensation for services are wage compensation and not a distribution of corporate earnings:
The corporation is a small business corporation with two shareholders, that has elected, pursuant to section 1371(a) of the Code, not to be subject to corporate income tax, but to have all its income taxed directly to its shareholders.
In 1972, the shareholders performed services for the corporation. However, to avoid the payment of Federal employment taxes, they drew no salary from the corporation but arranged for the corporation to pay them "dividends" of 100x dollars, which is the amount they would have otherwise received as reasonable compensation for services performed…
In the instant case, the "dividends" paid to the shareholders in 1972 were in lieu of reasonable compensation for their services. Accordingly, the 100x dollars paid to each of the shareholders was reasonable compensation for services performed by him, rather than a distribution of the corporation's earnings and profits. Such compensation was "wages" and liability was incurred for the taxes imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages.
It is essential to the above holding that the shareholders performed services for the S corporation. A shareholder who does not perform services for the S corporation is not required to receive wage compensation. Treas. Reg. §31.3121(d)-1(b) supports this, which states that a corporate officer who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.
It is not a surprise to tax practitioners that there is significant S corporation non-compliance with reasonable compensation requirements. In TIGTA Report 2021-30-042, the Treasury Inspector General for Tax Administration found the following:
The IRS examines less than 1% of S corporation returns, and when it does, officer compensation is not regularly evaluated.
Approximately 30% of S corporation returns with one shareholder did not report wage compensation.
Between 2016 and 2018, 266,095 returns were not selected for a field examination with (1) profits greater than $100,000 and (2) a single shareholder that did not report receiving officer’s compensation. These 266,095 returns did not report nearly $25 billion in compensation, and taxpayers may have avoided paying approximately $3.3 billion in FICA tax.
S corporation non-compliance can harm tax professionals who turn a blind eye to the issue. Eric Green, Esq. wrote a must-read article for RCReports about a case in which a tax professional had to file suit in federal district court over $130,000 in proposed §6694 preparer penalties because he continued to work with S corporations that consistently failed to pay sufficient wage compensation to their owners. While the preparer eventually settled the case with the Department of Justice, the settlement and legal fees totaled $34,500.
The shareholder wage amount affects many tax and non-tax financial attributes:
Payroll taxes. Minimizing shareholder wages decreases overall payroll tax liabilities; however, paying less than the reasonable compensation amount risks S corporation payroll tax liability on distributions paid instead of wages.
§199A deduction. Overpayment of S corporation shareholder wages reduces the S corporation’s qualified business income (QBI), which likely reduces the S corporation’s §199A deduction; however, if the taxpayer is over the taxable income threshold for the §199A limitations, increased wages could increase the §199A deduction in limited circumstances. Underpayment of S corporation shareholder wages should not increase QBI because reasonable compensation paid to the taxpayer is explicitly excluded as QBI per §199A(c)(4)(A).
Social Security benefits. Paying unreasonably low shareholder wages over many years can devastate a taxpayer’s Social Security benefits in retirement if the S corporation is the taxpayer’s only source of earned income.
Pass-through elective entity taxes. Overpayment of S corporation shareholder wages reduces the S corporation’s pass-through income, which in most states, reduces the income eligible for the state-level pass-through elective entity tax. State income taxes paid on shareholder wages will be subject to the $10,000 deduction cap.
Retirement contributions. If the maximum annual retirement contribution amount is tied to the shareholder’s wage compensation amount, then paying unreasonably low shareholder wages will limit the shareholder’s ability to defer income.
SECURE 2.0 catch-up retirement contribution rule. §603 of the SECURE Act 2.0 of 2022 requires, starting in tax year 2024, that if an employee’s wage compensation exceeds $145,000 (inflation-adjusted) in the prior tax year, any age 50 and over catch-up retirement contributions in the current year must be Roth contributions. Overpayment of S corporation shareholder wages may make a shareholder subject to this provision.
To assist taxpayers with tax choice of entity decisions, the practitioner must know the reasonable compensation amount for the business owners based on the services they plan to provide to the business. Without a reasonable compensation amount, running the scenarios required to determine the tax structure with the optimal tax outcome is almost impossible.
In the author’s opinion, every S corporation should do a regular analysis to ensure reasonable compensation is paid to its shareholders. RCReports is the best tool in the industry available; click here to schedule a consultation to learn more.
The next article in this series will review existing case law on S corporation reasonable compensation and how the courts have determined what is a reasonable amount.
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