S Corp Stockholders Must Take Reasonable Compensation

• Learn about S corporation compensation requirements.
• What is reasonable compensation?
• Learn the factors that determine reasonableness.
• Find out why reasonable compensation will be in the spotlight.
• Learn about the Sec. 199A deduction.

S corporation compensation requirements are often misunderstood and abused by owner-shareholders. An S corporation is a type of business structure in which the business does not pay income tax at the corporate level and instead distributes (passes through) the income, gains, losses, and deductions to the shareholders for inclusion on their income tax returns. If gains exist, we consider these distributions return on investment and therefore not subject to self-employment taxes. However, if stockholders also work in the business, they should take reasonable compensation for their services as wages. And wages, of course, are subject to FICA (Social Security and Medicare) and other payroll taxes.

This is where some owner-shareholders err by not paying themselves reasonable compensation for the services they provide. Some do it out of unfamiliarity with the requirements and some purposely to avoid the payroll taxes.

The Internal Revenue Code

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. 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 rather than as wages.

If the S corporation does not pay it's working stockholders a reasonable compensation for their services, then the IRS generally will treat a portion of the S corporation's distributions as wages and impose Social Security taxes on the deemed wages.

What constitutes reasonable compensation?

There is no specific method for determining what constitutes reasonable compensation, and it is based on facts and circumstances. Generally, it is an amount that unrelated employers would pay for comparable services under like circumstances and based upon the cost of living in the area where the business is located. The following are just some of the many factors that would be considered in making this determination:

• 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 a formula to determine compensation

The problem? The IRS can easily list contributing factors used by the courts in determining reasonable compensation. Then, they leave it to the corporation to quantify these factors into a reasonable salary. However, they still can challenge the selected amount later if an auditor decides the compensation is unreasonable.

The IRS has a long history of examining S corporation tax returns to ensure that reasonable compensation is being paid, particularly if no compensation is shown being paid to employee-stockholders.

Reasonable Compensation in the Spotlight

With the passage of tax reform, reasonable compensation will be in the spotlight because of the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will figure into the shareholder’s income tax return. The QBI for the stockholder of an S-corporation equals the amount of net income passed through to the stockholder and designated as QBI on the K-1. However, the stockholder may not include the reasonable compensation (wages) he or she was paid as QBI. Thus, wages paid to stockholders reduce the QBI because the S corporation deducts the wages as a business expense. This, therefore, reduces the corporation’s net income and QBI. But that does not mean wages can be arbitrarily adjusted to maximize the Sec. 199A deduction.

IRC Sec. 199A Deduction

Here are some details about how the 199A deduction works and the impact of reasonable compensation wages on the Sec. 199A deduction.

• The S corporation’s employee-stockholder’s wages are NOT included in qualified business income (QBI) when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and thus the smaller the 199A deduction, which is 20% of QBI. In this case, an S corporation would tend to pay the stockholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
• If married taxpayers filing a joint return have taxable income that exceeds $364,200 ($182,100 for other filing statuses), the 199A deduction begins to be subject to a wage limitation, and once the taxable income for married taxpayers filing a joint return exceeds $464,200 ($232,100 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. For these high-income taxpayers, an S corporation will tend to pay stockholders less wage income for them to benefit from the Sec. 199A deduction. Keep in mind that care must be exercised if distributions, rent, or other payments are taken by the shareholder as IRS can re-characterize those payments as compensation.
• If an S corporation is a specified service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between $364,200 and $464,200 (between $182,100 and $232,100 for other filing statuses). And although we use the wage limitation in computing the phase-out, once the taxpayer’s taxable income exceeds $464,200 ($232,100 for other filing statuses), the taxpayer will receive no benefit from the wage limitation. Therefore, they would again want to minimize their reasonable compensation to minimize FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services (for more information on what constitutes an SSTB, call your Fiducial representative).

Who can help?

Of course, taxpayers cannot pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for taxpayers who do not consider the factors related to reasonable compensation. There are commercial firms that have the data necessary to determine reasonable compensation and specialize in doing so. You can find these firms by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.

Want additional information related to reasonable compensation? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.

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