Many small businesses are formed as S corporations. S corps have been around for many years. Their popularity has a lot to do with the fact that s corporations offer both tax savings and a high degree of liability protection in the event of a lawsuit. While S corps are very popular, the issue of how much the owner of the business should be paid frequently comes up in IRS audits.
It is crucial for S corporations to pay reasonable compensation to shareholder-employees for their services. The IRS has the authority to reclassify payments if they determine that reasonable compensation is not being met, which can lead to potential tax penalties.
Entrepreneurs typically choose S corp status in order to minimize taxes. They can accomplish this with good tax planning. A key focus of tax planning for S corporations is centered on the issue of officer’s salary and “reasonable compensation.”
Definition of an S Corp
An S corp, also called an S corporation, is an entity type that is popular among business owners and entrepreneurs. Its popularity stems from the tax advantages that it offers. Lawyers tend to like S corps because they have been around for so many years and the legal precedent surrounding S corps is substantial, especially when compared to LLCs.
An S corp must be either a domestic corporation or an LLC. In addition, S corps are limited to 100 shareholders. The shareholders must be U.S. citizens or legal residents of the U.S. Shareholders of an S corp must be individuals, not corporations, partnerships or other entities. S corps may only have one class of stock.
In order to taxed as an S corp, the entity submits Form 2553, Election by a Small Business Corporation, to the IRS.
The annual S-corporation tax return is Form 1120-S. These returns are due on March 15 of the following year. A six month extension is available from the IRS upon request.
An S corp allows the income, losses, deductions and credits of the business to be passed through to the shareholders for federal tax purposes. Each shareholder receives a Schedule K-1 which reports their share of the activity of the business.
Shareholders of S corporations report the flow-through of income and losses of the S corp on their personal tax returns. The shareholders are assessed tax on their share of the earnings of the S corp at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. Business income is distributed to shareholders and impacts their individual tax returns, affecting reasonable compensation and potential tax deductions.
S Corp Tax Filing Statistics
In the 2022 fiscal year, the IRS received 5,583,837 tax returns from S corporations. This represents an increase of 4.3% from the prior year.
S corps are by far the most popular business entity type in the US, based on the number of tax returns filed with the IRS. This does not include single member LLCs, which are disregarded entities for tax purposes.
Source of data: 2022 IRS Data Book, Table 2.
Reasonable compensation for owners of S Corporations is an IRS audit issue. Let’s get it right.
Reasonable compensation is the perennial audit issue for S corporations. What exactly is the problem?
Owners of S corporations are both shareholders and employees. They are compensated in two ways:
- The business pays distributions to the owners. Distributions are subject to income tax, but not to payroll taxes (composed of Social Security tax and Medicare tax).
- The business pays wages or salary to the owners. Wages are subject to income tax and payroll tax. Wages are paid through payroll and will be reported on Form W-2 at the end of the year.
It is necessary that reasonable compensation paid to shareholder-employees for services rendered occurs before any non-wage distributions can be made. Failure to comply with this requirement can lead to IRS penalties and affect the qualified business income (QBI) deduction calculation.
Payroll Taxes on S Corp Salary
In order to understand the reasonable compensation issue, you need to first understand payroll taxes.
Payroll taxes are composed of Social Security taxes and Medicare taxes. The employer withholds these taxes from the employee’s paycheck. Payroll taxes are computed at a rate of 7.65% and are divided as follows:
- Social Security Tax: 6.2%
- Medicare Tax: 1..45%
In addition to the tax withheld from the employee’s salary, the business also pays its share of Social Security and Medicare taxes to the IRS. This employer’s share of the tax also equals 7.65%.
Therefore, total payroll taxes (both the employee’s portion and the employer’s portion) equals 15.3%. This applies to both shareholders who are employees of an S corp, as well as non-owner employees.
For example, $20,000 in salary paid to the shareholder/employee of an S corp results in $1,530 of payroll taxes withheld from the employee’s paycheck, plus $1,530 paid by the employer. This is a total tax of $3,060.
A higher salary results in higher payroll taxes. A lower salary results in lower payroll taxes.
Payroll Tax Forms to be Filed by S Corps
S corporations, as well as other businesses with employees, are required to file the following payroll tax forms:
- W-2 — Wage and Tax Statement: Shows employees wages and withholding taxes (federal and state).
- Form W-3 — Transmittal of Wage and Tax Statements: Summarizes all the W-2’s for the year.
- Form 941 — Employer’s Quarterly Federal Tax Return: Quarterly report of wages and taxes.
- Form 940 — Federal Unemployment Tax (FUTA) Return: Reports federal unemployment taxes (FUTA).
What is Reasonable Compensation for S Corporation Owners?
The IRS requires that W-2 wages or salary meet a standard of “reasonable compensation” for services provided to the business. Reasonable compensation is a minimum threshold. The company can pay more than the reasonable salary amount.
However, the calculation of a reasonable salary is frequently subject to debate. This is particularly relevant for S Corp owners, who must ensure they pay themselves an ‘s corp reasonable salary’ as defined by the IRS. It is important to align this salary with what others in similar roles receive to avoid IRS scrutiny. Proper documentation and adjustments based on unique business circumstances are crucial.
In practice, S corp owners prefer to maximize owner distributions and minimize owner payroll. A lower salary for the owner will reduce employment taxes.
In contrast, the IRS prefers that S corp minimize owner distributions and maximize owner payroll. A higher salary for the owner will increase employment taxes. Therein lies the conflict.
Do I Have to Take a Reasonable Salary from my S Corp?
In short, Yes! You do have to take a salary from your S corp. Salary (W-2 wages) is the tool that the IRS uses to ensure that S corporation owners pay their share of payroll taxes (self-employment taxes).
It will be obvious on your tax return if you do not take a salary from your S corporation, because the line for Owner’s Compensation on the return will be empty.
So, if you do not take a salary, the chances of being audited by the IRS are high.
IRS Audits: S Corp Distributions vs Salary
Shareholder compensation is frequently the subject of IRS audits. Auditors examine the books of the company to determine if the business paid sufficient wages to the owners to meet the reasonable compensation standard. This standard is a calculation that hinges on replacement cost of the worker, fair market value, job title and location of the business.
If the IRS auditor determines that an S corporation paid insufficient compensation to its owner, the IRS will reclassify distributions as wages subject to employment taxes. In such case, the business would become subject to additional employment taxes (plus interest and significant penalties), as if the business had paid the amount in question as wages. This is a risk that few business want to bear.
The expansion of IRS enforcement activity, set to begin in 2022, including massive funding increasing for IRS audit staff, will makes the situation worse. We expect that high income taxpayers and their S corporations will be the focus of IRS attention and IRS audits over the next few years. Compliance with reasonable compensation requirements will be an obvious target of these audits.
IRS Audits of S Corporations – Updated for 2023 and 2024
All indications show that the IRS auditors are going to go after S corporations in greater numbers in 2023 and 2024. If your S corporation is under audit, expect that the auditor will be looking to see if the owners were paid reasonable compensation.
If your S corporation is subject to a reasonable compensation audit, your CPA will have to prove your case as part of your audit defense. If you paid no officer’s compensation at all, that will be a very difficult challenge.
A compensation audit of an S corp in 2023 or 2024 may subject the business to a host of unpleasantness. Here is a list of what may happen:
- Reclassification of owner distributions to officer’s compensation: The IRS will charge the business for unpaid payroll taxes.
- Expect penalties for failure to pay payroll taxes
- Expect penalties for failure to file payroll tax returns
- Expect interest on unpaid taxes
How to Determine Reasonable Compensation for an S Corp
Reasonable compensation is a facts and circumstances determination, based on case law. Here are some of the factors that should be considered when calculating if wages or salary paid to the owner of an S corporation are reasonable or not:
- 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
- The use of formulas to determine compensation
As a rule, reasonable compensation is calculated as the cost to replace the employee (or owner) who is doing the work. We do not consider work in excess of 40 hours per week when determining a reasonable salary for S corps.
Reasonable compensation is not the same as the net income of the business. Furthermore, reasonable compensation is never an arbitrary percentage of the net income of the business.
Is There an S Corp Salary 50/50 Rule of Thumb? Or, How about a 60/40 Rule of Thumb?
The IRS and the courts do not recognize a “rule of thumb” related to compensation of S corporation shareholders. It is a myth that a 50/50 split between distributions and wages, or any other rule of thumb, is regularly accepted by the IRS when auditing S corporations.
In practice, it is usually highly advantageous to the taxpayer to determine compensation based on how much time the owner of the business spends on performing different tasks within the company. This is the “cost approach,” which is best to use when the owner provides many different services for the business.
Therefore, don’t guess and split the time down the middle between management and operational tasks. Rather, calculate compensation based on the cost of specific tasks, allocated according to the percentage of time spent doing those tasks.
How to Pay the Owner of an S Corporation
At our CPA firm, we generally recommend that our clients use a payroll company to handle the mechanics of issuing wages or salary to employees, including the officers of S corporations. Don’t do this yourself. Running payroll is a lot of work and it is easy to make a mistake that can cost you plenty in interest and penalties.
Here are some of the step to keep in mind relating to payroll:
- The business pays half of the payroll taxes (7.65%). The other half is paid by the employee (including the S corp shareholder) through withholding. These taxes are submitted to the IRS electronically on a regular basis throughout the year.
- Form 941 is submitted to the IRS on a quarterly basis. Form 940 is submitted to the IRS once a year.
- Form W-2 is provided to each employee at the start of the new year, with an electronic copy to the IRS and sometimes the state.
- The business is required to pay unemployment tax (FUTA) to the IRS, and often to the state as well (SUTA).
- The business may have to pay for worker’s compensation insurance and state disability insurance.
Remember, these steps apply both to payroll paid to the officers of the S corporation, as well as to other non-officer employees.
These steps do NOT apply to distributions taken by the officers of the S corp, which are not included in payroll.
There is no required frequency of payroll for s corporation officers. Sometimes officers take a few payrolls during the year, with a large payroll before year end. Also, the amount of individual payrolls is up to you, and may depend upon personal needs or the cash flow requirements of the business.
Important: You Need an S Corporation Reasonable Compensation Report for Your Payroll Files
Businesses should proactively determine reasonable compensation well before the audit starts. It is not enough to prove reasonable compensation after the audit starts.
We require that most of our S-corporation clients have a Reasonable Compensation Report on file. The Report contains detailed calculations as to how owner compensation was determined. The Report provides proof that the compensation of the owner complies with IRS standards for reasonable compensation. The Report includes highly detailed research, based on IRS criteria, court rulings, geographic data and our database of wages.
Our clients bring out their Reasonable Compensation Report in the event of an audit. In most cases, the resolves the audit nightmare before it even begins.
S Corp Salary Requirements: Additional Considerations and Tax Savings
Wages do not only impact reasonable compensation for the S corp business owner. They also impact maximum contributions to retirement plans. If wages are too low, the business owner may miss out on valuable tax deductions and retirement planning.
The same is true for calculations of social security benefits upon retirement, which are based on wage history.
At our CPA firm, we calculate compensation for S corporation shareholders in three ways:
- S corporation wages that meet the requirements of the IRS (reasonable compensation)
- S corporation wages that will allow the shareholders to maximize contributions to a retirement plan
- S corporation wages that will maximize social security benefits upon retirement
The result of this three-way calculation is what we call the S corp “sweet spot.” It is the wage level that will satisfy the IRS and allows you to maximize your future benefits. Amounts in excess of the sweet spot may be paid to the S corporation owner through distributions.
We recommend that all S corporations go through this calculation every year.
Do you have an S corporation? Are you considering an S corporation for your business? Call our accounting firm today to discuss an officer compensation plan that will withstand an IRS audit, and allow you to meet your retirement goals as well. We will run the numbers for you and give you a S corp wage report for your files that will stand up to the IRS.
Here are our office phone numbers: 678-235-5460 or 773-828-0551.
Or email us at: gary.massey@masseyandcompanyCPA.com.
We will keep our clients out of IRS trouble!
By Gary Massey, CPA and Austin Bell, EA
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, income tax planning for businesses and individuals, IRS tax problem resolution, IRS audits, sales taxes, and small business accounting and bookkeeping.
We want to be your CPA firm!
