S-Corporations have long been popular due to their single level of taxation as a pass-through entity and the shareholder’s share of the corporation’s net income is not considered self-employment earnings, and therefore, not subject to self-employment tax (15.3% in 2020). However, if the shareholder provides services to the S-Corp, he or she must receive reasonable compensation for those services, which is subject to Social Security and Medicare tax. The IRS has been aggressively pursuing companies abusing inadequate compensation in favor of dividend distributions to shareholder employees and has won a number of cases.
The IRS has the authority to reclassify dividends, distributions, or payments to shareholder-employees including loan repayments as compensation, if it deems compensation inadequate or unreasonable. When these payments are reclassified as compensation the IRS can assess interest, penalties and liability for additional payroll taxes.
How is “reasonable” compensation determined? The courts have held that the question of reasonable compensation is one of fact, determined on a case-by-case basis. The IRS posted on its website three major sources of gross receipts it will consider when determining reasonable compensation:
- The services provided by the shareholder: Compensation should be set at the fair market value for the services that the shareholder provides to the business. “Fair market value” means representative of what the company would pay to hire someone to perform the services or the amount the shareholder could reasonably ask for his or her services while working in a similar capacity elsewhere. The compensation should be documented in a written employment agreement outlining the services to be performed. If the company cannot pay the agreed upon compensation, the reasons should also be documented.
- The services of non-shareholder employees: Compensation of the shareholder should reflect the shareholder’s actual qualifications. The compensation set for someone with many years of experience and advanced degrees should be higher than an entry-level employee.
- The capital and equipment of the corporation: Many court cases involving reasonable compensation have involved professional service corporations such as sales, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated by the personal efforts of the employees. As a result, a significant portion of the profits should be paid out in compensation rather than distributions. Conversely, in a manufacturing or distribution business the revenue is driven less by the shareholder’s personal efforts and more by the capital and assets of the corporation. In these businesses, a lower salary can be justified for the shareholder-employees.
Remember that reasonable compensation is open to interpretation. The IRS and courts will consider the context of the facts and circumstances. With continued scrutiny from the IRS and even some members of Congress looking to tighten up this perceived loophole, S-Corporation reasonable compensation will continue to be a hot button issue.
If you need help with your estimated tax payment, don’t hesitate to contact a Henry+Horne professional adviser.