Theoretically speaking that is.   This is to clear up some confusion regarding the recent “tax cut” that became effective April 1, 2009.

• You will not be getting a physical check as was done previously.  The tax reduction is reflected in your paycheck withholdings.
• Everyone with earned income is eligible for the tax reduction (unless you have too much income).
• The withholding tables were adjusted effective April 1st 2009 to increase the take home pay of those that are eligible.
• The credit is $400 for single filers and $800 for married filers however it cannot exceed 6.2% of your earned income.
• If you make too much money you do not get the credit, it is phased out beginning at $75,000 for single filers and $150,000 for joint filers.
• The credit is “refundable” which means that even if you owe no tax but are otherwise eligible, you will get the credit and a refund check will be issued when you file your return.
• The credit is effective for the 2009 and 2010 tax years.

Any questions?

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
• 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

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.

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3 Comments

• At December 12, 2009, Stuart Pumphrey wrote:

  Mr. Howes,

  I found this interested article of yours while researching self employment and S corporation tax options for a college paper I am writing. I am writing on a real life situation I know of and it approaches this employment tax issue from a different direction. My sister, her husband and a couple friends formed an S corporation to run a medical billing service for doctors. In the end it has come to my sister doing all the work and she owns 55% of the stock so she has essentially full control of the business. The issue with employment taxation is not that she underpays herself and tries to capture the rest as stick disbursement, quite the opposite. She gives herself almost all of any left over profit after paying the company bills to herself. She pays herself sporadically with no set amount over time. She pays herself anywhere between $90,000 to $120,000 a year. She also pays herself and reports her earnings on a 1099 as non-employee compensation. What are your views of a S corporation officer doing the full work of the company for over twenty years now treating herself as an independent contractor rather than an employee of the firm?

  I am interested in you opinion,

  Thank you

  Stuart Pumphrey

• At December 30, 2009, cpajohn wrote:

  @Stuart Pumphrey,

  The determination of independent contractor versus employee is a complex issue beyond the scope of this post.

  I would refer you to this case:

  http://ftp.resource.org/courts.gov/c/F2/918/918.F2d.90.89-35071.html

  And specifically this language contained within the case:

  Taxpayer also argues that Mr. Spicer could not be an employee because he was a common law independent contractor. In determining whether Mr. Spicer is an employee or an independent contractor, several factors we consider are whether the business furnishes the worker with tools and a place to work, and "whether the work is performed in the course of the individual's business rather than in some ancillary capacity." General Investment Corp. v. United States, 823 F.2d 337, 342 (9th Cir.1987). We also consider whether the services performed "constitute[ ] an integral part of taxpayer's business and [are] not incidental to the pursuit of a separately established trade or business." Westover v. Stockholder's Publishing Co., 237 F.2d 948, 952 (9th Cir.1956).

  18

  We find that Mr. Spicer is not a common law independent contractor, because Taxpayer provided him with supplies and a place to work, and he performed accounting services for no other accounting firm. Moreover, Mr. Spicer's services were integral to the operation of Taxpayer, as he was the only accountant in the accounting concern, the only one who signed customers' returns as preparer, the only one who performed financial planning for the firm, and the only one who audited clients' books.

  19

  Taxpayer also argues that in light of the Idaho Industrial Commission's determination that Mr. Spicer was an independent contractor, rather than an employee, for state employment tax purposes, the government is precluded from again raising the issue of Taxpayer's treatment of Mr. Spicer for federal employment tax purposes. Because the government was not a party, nor in privity with the State of Idaho, in the prior state administrative action, it is not bound by the Idaho State Industrial Commission's holding, and again could challenge Mr. Spicer's status for federal income tax purposes. See United States v. ITT Rayonier, Inc., 627 F.2d 996, 1000 (9th Cir.1980) (citing Parklane Hosiery Co. v. Shore, 439 U.S. 322, 326 n. 5, 99 S.Ct. 645, 649 n. 5, 58 L.Ed.2d 552 (1979)). Accordingly, we affirm the district court as to this issue.

  The burden of proving independent contractor status based on the limited facts you have provided would appear to be difficult.

• At January 6, 2010, RJP wrote:

  My Partner and I have an S-Corp together. We pay ourselves a salary of $120K each. We had a profit this year of about $100K. Our current Tax person advised we just pay ourselves a bonus of $50K each. Looking at that paystub though we sent a large chunk out in Taxes. Is this a case where doing a "Distribution" would perhaps have been a better idea?