I own my own S Corporation – what should I pay myself?
More than 4 million U.S. businesses defined as “small businesses” elect to be S corporations for federal income tax purposes. For small business owners preferring the corporate form of ownership, the election to be taxed as an S corporation has certainly been the most preferable choice given the S corporation’s pass-through nature of income and single level of taxation.
Besides its single level of taxation as a pass-through entity, an advantage of an S corporation over a regular corporation (C corporation in tax lingo) is that a shareholder’s share of the corporation’s net income is not considered self-employment earnings and therefore is not subject to self-employment tax (13.3% in 2011 and 2012). Compare this to a sole proprietor, general partner, or LLC member where net earnings form self-employment include the owner’s distributive share of any trade or business income carried on by the sole proprietorship, partnership or LLC.
However, most S corporation owners are very active in the business operations and are, therefore, providing significant services to the S corporation. When the S corporation shareholder provides services to the S corporation, the IRS requires that he or she must receive an adequate or reasonable amount of compensation for these services. The S corporation is allowed to deduct the compensation paid to the shareholder and must pay the employer share of employment taxes (6.2% Social Security tax and 1.45% Medicare tax). The shareholder-employee is responsible for 4.2% Social Security tax (in 2011 and 2012) and 1.45% Medicare tax. The S corporation is also responsible for Federal Unemployment Tax Act (FUTA) taxes. Minimizing these taxes provides an incentive to keep the S corporation shareholder’s wages low and to characterize most of the pass-through income as dividend distributions. This incentive becomes even more important beginning in 2013 when high-income earners will be subject to an additional 0.9% Medicare tax.
The U.S. Government Accountability Office reported in 2009 on employment tax noncompliance among S corporation shareholders. The IRS has been pursuing this perceived abuse of inadequate compensation in favor of dividend distributions to shareholder-employees and has won a number of cases. Several of these cases won by the IRS have involved businesses in service-oriented businesses such as accounting, law, consulting, engineering, etc. Many service-oriented S corporations require significant involvement by their owners and require very little in the way of capital (i.e. machinery, equipment, human capital). An S corporation business generating profits primarily through the efforts of its owners may have a hard time convincing the IRS that a large portion of the profits should be paid out as distributions versus shareholder wages.
The IRS has the authority to reclassify dividends, distributions, or payments to the shareholder-employee, including loan repayments, as compensation if it deems compensation inadequate or unreasonable. The courts have held that the question of reasonable compensation is one of fact, determined on a case-by-case basis. The IRS has posted on its website three major sources of gross receipts it will consider when determining reasonable compensation: the services provided by the shareholder, the services of non-shareholder employees, and the capital and equipment of the corporation.
IRS fact sheet FS-2008-25, Wage Compensation for S Corporation Officers, lists the following factors in determining reasonable compensation: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, timing and manner of paying bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and the use of a formula to determine compensation. Sources of information on comparable compensation for services include the U.S. Department of Labor’s Bureau of Labor Statistics, employment agencies, and a market analysis.
The S corporation entity form provides planning opportunities to avoid payroll taxes or self-employment taxes on distributions that are instead a return on capital and assets. With the increase in Medicare tax of an additional 0.9% for high-wage earners scheduled to begin in 2013, this may represent a larger opportunity. The key in defending against a possible audit and re-characterization of dividends is to document all research and analysis of the determination of the shareholder-employee salary. It is a must for all S corporation shareholders to have a conversation with their professional tax advisors about the importance of paying reasonable compensation to the shareholder-employee and how the IRS may apply the reasonable compensation guidelines to the S corporation’s specific fact and circumstances.