The issue of what reasonable compensation for shareholderemployees of S corporations should be has been around for some time. Every time the IRS accepts a Form 2553, “Election by a Small Business Corporation,” it sends a CP26I.
“Notice of Acceptance as an S Corporation.” This acceptance letter specifically einphasi/es the requirement for shareholder- employees to be paid reasonable compensation for the services that they provide to the corporation. The IRS has increased 38 its interest in this area over the past few years, and it is now more likely than ever that the adequacy of a shareholderemployee’s salary could become the subject of an IRS audit. Why Reasonable Compensation Is an Issue One of the advantages of the S corporation business model is the absence of the double taxation inherent in the C corporation model. S corporations are flow-through entities whose ordinary busi- MAY 2D10 / THE CPA JOURNAL ness income is taxable income to the corporation’s shareholders. Ordinary business income is passed through to shareholders in proportion to their ownership interests via reporting cm Schedule K-l. The S corporation is therefore not taxed at the entity level, and the ordinary business income is taxable for federal purposes to individual shareholders on their Form 1040. The ordinary business income passed through to owners is not subject to RCA (Federal Insurance Contributions Act) or FUTA (Federal Unemployment Tax Act) taxes, and it is not subject to self-employment tax (Revenue Ruling 59-221, 1959-1 C.B. 22). These employment taxes comprise Medicate, Social Security, and unemployment taxes. Partnerships and LLCs electing to be treated as partnerships are also flowthrough entities, but all ordinary business income is subject to FICA taxes. It is this difference in the treatment of employment taxes that can cause issues for taxpayers and where CPAs can provide valuable assistance. Salary payments are subject to employment taxes via the employee withholding and employer matching requirements. Shareholders who also work for their own S corporation can save a significant amount of employment taxes if they choose to pay themselves little or no salary’.
Exhibit I shows a simple Excel spreadsheet that can be used to analyze the difference between total tax liability for a shareholder-employee of an S corporation at different salary levels. The table shows that the lower the shareholder’s salary, the less the total tax liability. The taxes on paying a salary of $60,000 compared to no salary are $27,679 – $19,479 – $8,200—a significant savings. Not paying any salary would be an automatic red flag to the IRS, however. A shareholderemployee might set a desired salary at $60,000, but if a reasonable salary is actually $30,000, this would require paying $3,974 ($27,679 – $23,705) more in taxes than is necessary. The IRS wants to prevent this potential loss of tax revenue due to the manipulation of employment taxes, and tax advisors can help clients avoid the potential overpayment of salary and the resulting extra taxes. In order to address this issue, the first step is to establish who is an employee of the corporation.
Who Is an Employee? As mentioned earlier, a shareholderemployee who provides services to a corporation is expected to be paid reasonable compensation and is therefore an employee. An individual hired in the ordinary course of business—not a shareholder or an officer, who is compensated as such— is obviously an employee. In addition, a 2008 IRS fact sheet specifically includes corporate officers within the definition of “employee” for FICA, FUTA, and federal income tax withholding purposes Unless the corporate officers provide only minor or no services, any compensation they receive or are entitled to receive is subject to federal employment taxes. This is noted in the IRS’s instructions for Form 1120S, line 7, which cautions: “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 tax law thus requires a reasonable salary to be paid to shareholderemployees and officer-employees. If this is not done, the IRS can recharacterize dividends paid in lieu of reasonable compensation as salary under Revenue Ruling 74-44. In addition to classifying payments as dividends, a corporation may classify payments as loans to shareholders or as distributions other than dividends. Regardless of the recorded form of the payment, if reasonable compensation has not otherwise been made, such payments can be reclassitled as compensation. This position has been supported by several court cases: • Joh c. Cvnvn V. 211 F.3d 1269,6m Cir., 2000 (payments received by the taxpayer were compensation for services, not loans) • Veterinary Surgical Consultants. P.C. v. Comm’r, 117T.C. 141, 2001 (The president of the corporation performed “substantial services”: therefore, the remuneration he received was as an employee whose wages were subject to federal employment taxes.) • Joseph M, Grey Public Accountant. P.C. v. Comm’r, 119 T.C. 121, 2002 • Mike J. Graham Trucking, Inc. v. Comm’r, T.C. Memo 2003-49, affirmed, unpublished opinion. 3rd Cir., 4/7/2004 • Superior Proside, Inc. v. Comm’r, T.C. Memo 2003-50, affirmed, unpublished opinion, 3rd Cir., 1/28/2004, ccit. denied, 125 S.Ct. 60, 10/4/2004) • Specialty Transport and Delivery Services, Inc. v. Comm’r, T.C. Memo 2003-5 Knot appealed EXHIBIT 1 Fax Liability Comparison Table for Different Shareholder-Employee Salary Levels X, 100% shareholder, single, claiming standard deduction Ordinary business income before shareholder salary $100,000 Reasonable salary S 60,000 Salary S Corp. Income (K-1) AGI Personal Exemption and Standard Deduction Taxable Income Federal Income Tax Liability Employee FICA (7.65%) Employer Matching (7.65%) FUTA and SUTA (6.2% x max. $7,0001 Total Tax Liability High $60,000 534,976 594,976 (S 8,950) $86,026 $18,065 $4,590 S 4,5SO S 434 $27,679 Medium $30,000 Low $ 0 $67,271 S 100,000 $97,271 S 100,000 ($ 8,950) ! ($ 8,950) $88,321 $18,681 $ 2,295 S 2,295 S 434 $23,705 $ 91,050 $ 19,479 $ 0 $ 0 $ 0 $ 19,479 MAY 2010 / THE CPA JOURNAL 39 EXHIBIT 2 Salary Distribution Curve tor a Retail Store Manager Retail Stare Manager In Daytana Beach, Ra. 32118 10th% 25th% 75th% 90th% 535,459 Source: Salary.com $40,261 S54.412 562,495 Benefit Base Salary Bonuses Social Security 401k/403b Disability Healthcare Pension Time Off Total Median $42,884 $2,650 $3,483 $1,639 S455 $5,722 $2,095 $5,954 $64,883 % of Total 66.1% 4.1% 5.4% 2.5% 0.7% 8.8% 3.2% 9.2% 100% Source: HR Reported data as of September 2009 Job Description: Retail Store Manager Plans and directs the day-to-day operations of a retail store. Develops strategies to improve customer service, drive store sales, and increase profitability. Ensures customer needs are met, complaints are resolved, and service is quick and efficient Ensures all products and displays are merchandised effectively to maximize sales and profitability. Forecasts staffing needs and develops a recruiting strategy to provide optimal staffing in all areas. May require a bachelor s degree or its equivalent at least five years of experience in the field or in a related area. Familiar with a variety of the field’s concepts, practices, and procedures. Relies on extensive experience and judgment to plan and accomplish goals. Leads and directs the work of others. Typically reports to Retail Store Manager, Senior. • Nu-Lovk Design, Inc. v. Comm’r, T.C. Memo 2(103-52, affirmed, 356 F. 3d 290, 3id Cir., 1/26/2004, cert, denied, 125 S.Ct. 60, 10/4/2004 • Water-Pure Systems, Inc. v. Conun’r, T.C. Memo 2003-53, affirmed, unpublished opinion, 3rd Cir., 4/7/2004 For a more detailed discussion of these cases, see James A. Fellow’s and John F. Jewell. “S Corporations and Salary Payments to Shareholders,” The CPA Journal, May 2006. In all of these cases, individual shareholders or officers who were providing services to the S corporation were deemed to be employees and were therefore liable for PICA and FUTA taxes, as well as accrued penalties and interest. These penalties included failure to deposit, failure to file, and negligence penalties. Under IRC section 6656, a 10% penalty may be imposed on the amount due for failure to make the deposit in a timely manner. The amount due includes both the PICA and FUTA due and the required federal withholding tax that should have been deposited. IRC section 6651, which applies to Forms 941 and 940 employment tax returns, imposes a penalty of up to 25% of the amount due. Under IRC section 6662, a penalty of 20% of the underpayment of taxes can be imposed if it is due to negligence or disregard of regulations or rules. Collectively, these penalties are a very significant deterrent and a major reason to pay shareholderemployees a reasonable salary. But what is a reasonable salary? Factors in Determining Reasonable Compensation There are no specific guidelines for reasonable compensation in cither the Internal Revenue Code or Treasury Regulations. Under audit, if no agreement can be reached as to what is reasonable compensation, the courts will rule on the issue, basing its determination on the specific facts and circumstances. The IRS has said that the following factors will be 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 nonsharcholder employees 40 MAY 2010 / THE CPA JOURNAL • 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. (www.irs.govi/newsroom/article/0,,id=20 0293,(X).html) Practical Steps Although the courts treat each case on an individual basis, the main factors the officer or shareholder-employee should consider can be found in the answer to the question: “What would you have to pay someone else to do your job?” This question requires several of the factors listed above to be considered. For example, consider the owner of a small sporting goods store who recently incorporated his business and elected to be treated as an S corporation by filing Form 2553. He is now an employee of his own business and needs to establish and pay himself a reasonable salary. The advisor’s starting point is to ask him the question: ‘”What would you have to pay someone else to do your job?” The main factors to consider arc training and experience, duties and responsibilities, time and effort devoted to the business, and what comparable businesses pay for similar services. The following are ways that a CPA can help such a client use these factors to come to a reasonable salary. • An online salary search is usually quick and painless. One useful site is ww\\ .saliuy.com. Its salary wizard allows a user to search job titles and ZIP aides to see base salary distributions in an area (Exlubit 2). For a fee, a detailed personalised report can be created tailored to a specific job. This type of detail would be very persuasive in establishing a reasonable salary. • A visit to a local employment agency can be a source of useful information. Though it may be a little awkward to explain the situation, an agent may be willing to assist in providing salary information. This encounter can create a good impression and start a professional relationship. • To get a general idea of what an officer’s salary amount might be as a percentage of business sales, go to www.bizslats.com. This site has been used by some IRS agents to assist them in assessing the overall reasonableness of the expenses reported; though not official in any way. it may still help. • There are several different formulas floating around that CPAs can use. such as the 60-40 approach described by Fellows and Jewell in “S Corporation Profits or Payday” (Journal of Accountancy, want to consider a salary somewhere between the 25th and 75th pcrcentilcs.
Making the Case Whatever methods arc used, a gixid idea might be to put together a checklist of steps to be reviewed with a shareholder-owner of an S corporation: n salary. A prudent shareholder-employee will do the necessary research and document how the reasonable salary was established. September 2007). This formula uses a split of 60% salary and 40% distributions (or some variation thereof). Salary could be based on a percentage of net business income before the salary deduction, or it could represent a percentage of gross revenue. • Posting a question on a state society’s discussion tbrum can provide a wealth of information from fellow CPAs about their experiences with the issue. For example, the author posted the following question on the Florida Institute of CPAs listscrv (map_topics.listmanager@ webboardficpa): ”Has anyone assisted an S corporation client where the IRS said the shareholderemployees salary was not reasonable? If so, what factors did the agent look at in determining what they felt was reasonable, and what arguments, if any, were you able to use to assist your client in establishing a lower salary?’ Several useful responses were posted and contacts made to enable further discussion. • The U.S. Department of Labor’s Bureau of Labor Statistics provides an excellent source of salary information at www.bls.gov. Salary information can be accessed by subject area, metropolitan area, and occupational group to create customized tables and statistics on the selected occupation. In determining a reasonable salary, a shareholder-employee may • Discuss the need for a reasonable salary to be established. • Explain the tax savings that can occur and run the numbers, while emphasizing the need for the salary to be deemed reasonable. • Assist in providing sources to assess what a reasonable salary is, as mentioned above. • Document all research done in establishing the salary. • Periodically rcevaluate the adequacy of the salary based on changing economic factors and job markets. A shareholder-employee of an S corporation must be paid a reasonable salary. A prudent shareholder-employee will do the necessary research and document how the reasonable salary was established CPAs can assist in this process. A truly reasonable salary, subsequently reported on the Form 1120S, will likely reduce the chances of being audited. But if an audit occurs, a reasonable IRS agent should appreciate the work and documentation provided and be more inclined to agree that the salary is. in fact, reasonable.
J John R. Ledgerwood, MS (Ace.), CPA, CMA, CFM, is an assistant professor of accounting at Embry-Riddle Aeronautical University, Daytona Beach, Fla.. and president of John R. Ledgerwuod, CPA, PA. MAY 2010/THE CPA JOURNAL 41
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