Work and play are pretty much the same thing, according to Mark Twain,  just under different circumstances.

Work you get paid for. Or you should. And if you’re an S corporation shareholder who also works in the business (providing anything other than minimal services), the IRS will see that you do.

IRS rules require that you receive reasonable compensation for your work. Reasonable compensation in this context is wage income, not distributions or other non-wage payments. In other words, a reasonable portion of the cash and property you receive from the corporation each year should be reported on your federal income tax return as wages.

It matters to the IRS because the taxes you owe the federal government depend on how the payments you receive from the corporation are categorized: as compensation or as distributions. Compensation is subject to both income and employment (payroll) taxes – including the new Medicare surtax – while distributions are considered income not subject to employment taxes.

This different tax treatment creates an incentive for S corporation shareholders to keep their compensation low and categorize payments as distributions. That makes it a hot topic and a heavily scrutinized issue for the IRS.

According to the IRS, “S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans …”

Why should you care? At the risk of being considered glib, because the IRS cares – and it’s watching. The consequences of being found in the wrong can be considerable, including sizable penalties for late and incomplete tax filings, additional employment tax liabilities and associated penalties, and erroneous 1040s that must be amended, possibly with additional taxes due.

S corporations are, by definition, businesses with limited ownership structures. In fact, nearly three-quarters of all S corporations have only one shareholder. As a result, shareholders in an S corporation have near-total discretion over corporate decisions regarding compensation and distributions.

Many of these shareholders also work in the business as employees, or as officers who are considered employees for tax purposes. Given the tax incentives, they have an understandable tendency to categorize payments from the corporation as distributions. In fact, in a 2009 report the U.S. Government Accountability Office found that S corporations – primarily those with only one or two shareholders – under-reported shareholder compensation by more than $20 billion in 2003 and 2004.

An often-cited example is that of an S corporation shareholder-officer who owns 100 percent of the corporate stock and receives a total of $100,000 from the corporation during the year.

bullet graphic: green arrow  If the cash paid to the shareholder is considered compensation, the taxable income to the corporation is reduced by $100,000 and the taxable income of the shareholder is increased by $100,000. The corporation pays the employer’s share of payroll taxes on $100,000 of compensation. The shareholder pays both income tax and the employee’s share of payroll taxes on the $100,000.

bullet graphic: green arrow  If the cash is considered a distribution, the corporation has no expense for wages so its income is $100,000 higher than in the previous scenario. However, for tax purposes that income flows through to the S corporation shareholder’s income tax return, so the shareholder reports $100,000 of taxable income under either scenario. The difference is in the payroll tax liability. As a general rule, a non-wage distribution is not subject to payroll taxes at the corporate or individual level, so no payroll taxes are due. The total payroll savings can be sizable, including Medicare (2.9 percent) and FICA (12.4 percent on the first $113,700) as well as the Medicare surtax, federal and state unemployment, and state worker’s compensation.

Determining Reasonable Compensation
Not surprising given the amounts involved, there is a history of court rulings against S corporations with shareholders who receive no compensation for their work in the business. The cases including many in the professional services sector where shareholders who are practicing CPAs, attorneys, architects, engineers and consultants make significant contributions to corporate revenue.

Courts have also ruled against S corporation shareholders who were compensated, but in amounts considered to be unreasonably low.

These courts have used a variety of criteria to determine the reasonableness of compensation, including whether the amount of compensation would be approved by an independent investor. In general, courts have looked to such factors as the employee’s qualifications and the scope of his or her work, the nature of the business, the compensation amount as a percentage of corporate income, and comparisons with compensation paid to non-shareholder employees and those in comparable positions with other companies.

Unfortunately, the tax code doesn’t provide definitive guidelines for determining reasonable compensation. But relatively low salaries — particularly in conjunction with higher corporate income and distributions – will likely be subject to scrutiny.

To aid in determining reasonable compensation, the IRS published a Fact Sheet that summarizes the factors to consider, as follows.

bullet graphic: green arrow  training and experience

bullet graphic: green arrow  duties and responsibilities

bullet graphic: green arrow  time and effort devoted to the business

bullet graphic: green arrow  dividend history

bullet graphic: green arrow  payments to non-shareholder employees

bullet graphic: green arrow  timing and manner of paying bonuses to key people

bullet graphic: green arrow  what comparable businesses pay for similar services

bullet graphic: green arrow  compensation agreements

bullet graphic: green arrow  the use of a formula to determine compensation

Additional Tax Considerations
S corporations that pay accident or health insurance premiums on behalf of certain shareholders — those who own more than two percent of the company — are required to report the amount of these fringe benefits as wages. The amount of insurance premiums paid on behalf of shareholders is deductible by the corporation as a fringe benefit, as long as it is reported on Form W-2.

The shareholder must report the amount of the premiums as gross income on his or her personal income tax return. This amount is subject to income tax withholding, but is not subject to FICA or FUTA.

Note that health insurance premiums can either be paid as part of a company plan or be reimbursed by the company, if the shareholder provides adequate documentation.

If the IRS finds that the compensation you’re paid for work as an employee or officer of the S corporation is unreasonably low, it can reclassify (as wages) some or all of the distributions you receive. It can also levy sizable penalties.

An S corporation that files an income tax return (IRS Form 1120S) without including required information – perhaps omitting or incorrectly reporting shareholder distributions – is subject to penalty and interest. The current amount of the penalty (indexed for inflation) is $195 per shareholder, per month, for a period of up to 12 months.

If the information the S corporation provides its shareholders on Schedule K-1 is incomplete or incorrect, the corporation is also subject to a $100 penalty for each of these K-1s. If the error is intentional, the penalty increases to the greater of $250 per K-1 or 10 percent of the total amount required to be reported.

The S corporation may also be subject to penalties and interest for filing incorrect employment tax returns if it under-reports shareholder wages.

Finally, if a shareholder under-reports income on his or her personal return as a result, the shareholder must file an amended return and pay any additional income and employment taxes due, plus any applicable penalties and interest.



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