Ensuring that an S corporation pays reasonable compensation to a shareholder-employee in exchange for services provided by the shareholder-employee is important in protecting both from assessments of tax, penalties, and interest. S corporation shareholders must include in income their pro rata share of the S corporation’s earnings for the year. A shareholder-employee is not subject to self-employment taxes on a deemed or actual distribution of S corporation income, and the corporation does not pay any employment-related taxes on the distribution (Sec. 1373; Rev. Rul. 59-221). Conversely, a shareholder-employee and the S corporation are subject to employment taxes on a compensation payment for a shareholder-employee’s services.
As a result, S corporations often try to disguise compensation payments for services as income distributions. Ultimately, the determination of whether payments to a shareholder represent compensation for services or constitute a distribution of profits is essentially a factual determination.
Paying reasonable compensation
Before nonwage distributions are made to an S shareholder, reasonable compensation must be paid to any S shareholder providing services to the corporation. The IRS typically scrutinizes distributions by an S corporation to a shareholder-employee to ensure that the corporation is not avoiding the payment of employment taxes by disguising compensation payments as dividend distributions. Because nonwage distributions by an S corporation to a shareholder are not subject to self-employment or payroll taxes, an IRS audit of an S corporation return will typically focus on whether reasonable compensation has been paid to shareholder-employees and whether the appropriate amount of employment-related taxes has been paid.
The IRS has the authority to reclassify S corporation distribution payments as wage payments subject to employment taxes (Sec. 7436; Rev. Rul. 74-44). For federal employment tax purposes, the term “wages” is defined as all remuneration for employment (Secs. 3121(a) and 3306(b)). The form of payment is immaterial; instead the relevant factor is whether the payment was actually received as compensation for employment (Regs. Secs. 31.3121(a)-1(b) and 31.3306(b)-1(b)). Consequently, an S corporation shareholder who performs substantial services for the S corporation, and who receives remuneration in any form for those services, is considered an employee whose wages are subject to federal employment taxes. In addition, as the employer, the S corporation is also liable for its share of employment taxes on those wages (Veterinary Surgical Consultants, P.C., 117 T.C. 141 (2001), aff’d sub nom., Yeagle Drywall Co., 54 Fed. Appx. 100 (3d Cir. 2002)).
Officers and shareholders
Taxpayer arguments that payments by an S corporation to an S shareholder are attributable to his or her status as an officer and shareholder, rather than his or her status as an “employee,” have been rejected by the courts. An officer of an S corporation is considered an employee of that corporation, unless he or she performs only minor services (Sec. 3121(d)(1); Veterinary Surgical Consultants, P.C., 117 T.C. 141 (2001); Joseph M. Grey Public Accountant, P.C., 119 T.C. 121 (2002), aff’d, 93 F. Appx. 473 (3d Cir. 2004)).
If a family member of one or more S shareholders renders services for, or furnishes capital to, the S corporation without receiving reasonable compensation, the IRS may determine any adjustments necessary to reflect the value of the services rendered or capital furnished. In determining the reasonable value for services rendered, or capital furnished, to the corporation, the IRS must consider all the facts and circumstances, including the amount that ordinarily would be paid in order to obtain comparable services or capital from a person (other than a member of the family) who is not a shareholder in the corporation.
In addition, if a member of the family of one or more shareholders of the S corporation holds an interest in a passthrough entity (e.g., a partnership, S corporation, trust, or estate) that performs services for, or furnishes capital to, the S corporation without receiving reasonable compensation, the IRS can prescribe adjustments to the passthrough entity and the corporation as may be necessary to reflect the value of the services rendered or capital furnished. For this purpose, the term “family of any shareholder” includes only the shareholder's spouse, ancestors, lineal descendants, and any trust for the primary benefit of any of these individuals (Regs. Sec. 1.1366-3).
What is reasonable?
In determining what constitutes “reasonable” compensation, the IRS looks at the source of the S corporation’s gross receipts and at what the shareholder-employee did for the S corporation to help generate those receipts. The three major sources of gross receipts are services of shareholders and nonshareholder employees, capital, and equipment.
Gross receipts generated by services of nonshareholder employees and capital and equipment are treated as nonwage distributions to the S shareholder that are not subject to employment taxes. But if gross receipts are generated by the shareholder’s personal services, then payments to the shareholder-employee are classified as wages that are subject to employment taxes.
The shareholder-employee is also subject to wage treatment for administrative work he or she performs. This would apply, for example, where an S shareholder-manager does not directly produce gross receipts but does assist other employees who are producing the day-to-day gross receipts.
Some factors used by the IRS to determine reasonable compensation include:
Training and experience;
Duties and responsibilities;
Time and effort devoted to the business;
Payments to nonshareholder employees;
Timing and manner of paying bonuses to key people;
What comparable businesses pay for similar services;
The use of a formula for determining compensation; and
Amounts paid out as salary compared with the amount distributed as profits.
Finally, the determination of what constitutes reasonable compensation in an S corporation can also play a role in the computation of an S shareholder’s qualified business income (QBI) deduction under Sec. 199A. This is because S corporation shareholders are allocated their pro rata share of the S corporation’s QBI, and the S corporation deducts W-2 wages (which includes reasonable compensation paid to S shareholders), as an expense properly allocable to its trade or business, in calculating its QBI (Regs. Sec. 1.199A-2(b)). However, it is important to note that an S shareholder cannot increase his or her QBI for reasonable compensation received from the S corporation (Regs. Sec. 1.199A-3(b)(2)(ii)(H)). In addition, reasonable compensation is W-2 wages for purposes of determining the W-2 wages/UBIA limitation on the QBI deduction.
Steps to take
When preparing a tax return for an S corporation, the underlying workpapers should include detailed documentation that supports the payment, or nonpayment, of wages to an S corporation shareholder-employee. For a shareholder earning wages, the documentation should include the type of work performed by the shareholder and the hours devoted by the shareholder to the S corporation’s activities, as well as documentation of what a person doing comparable work at another organization would be paid. The U.S. Department of Labor’s Bureau of Labor Statistics provides detailed wage data for more than 800 occupations broken down by location (e.g., state, metropolitan area, nonmetropolitan area, etc.) and is a good source for providing this documentation.