Average salaries of faculty of California State University faculty 2007
There has been considerable controversy and misinformation regarding S corporations and wages paid to officers of the corporation. The controversy arises from the fact that to the extent an officer/shareholder underpays his salary, the corporation’s net income may be higher, thereby reducing social security and medicare taxes since the net income attributable to the shareholder of an S corporation is not subject to these taxes. I recently represented an S corporation shareholder (not a previous client of mine) before the IRS on this very issue and the end result was a disaster to the client.
The shareholder/officer was paid approximately $15,000 – $20,000 in annual salary and the net income of the S corporation was approximately $60,000 to $70,000 over a number of years. Here is some IRS guidance on this issue:
FS-2008-25, August 2008
Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.
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.
This fact sheet clarifies information that small business taxpayers should understand regarding the tax law for corporate officers who perform services.
Who’s an employee of the corporation?
Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.
The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.
What’s a Reasonable Salary?
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation
Since there was really no evidence that could be found to support the low salary originally paid, the IRS recharacterized almost all of the net income of the corporation as wages for this shareholder/officer. This resulted in penalties for failure to withhold and pay payroll taxes. The end result is the client ended up paying about double in taxes, interest and penalties over what would have been owed had the income been classified as officer wages from the beginning.
The client consulted an attorney to consider going to court over the matter. The attorney ironically had also been audited on the very same issue, had gone to court and lost. So he advised the client to just bite the bullet and pay the assessment.
The IRS has been going after this issue in a big way. If you are a shareholder/officer in an S corporation, careful consideration is required of the reasonableness of your compensation in order to avoid a possible nightmare like this down the road.