Employees of closely held corporations, whether structured as a C corporation or an S corporation, who also serve as shareholders of that same corporation, may find themselves in a precarious position when it comes to determining their compensation.
Shareholder-employee compensation is one management area to which leadership teams should pay close attention. In the eyes of the IRS, providing unreasonably high or low compensation to a shareholder-employee can be a bright, red, fast-waving flag.
Why?
Since S corporations are taxed similarly to partnerships, (income is passed through to the shareholders, instead of the corporation paying tax on the income), and since S corporation income is not subject to Self-Employment (SE) tax, it is an obvious move for shareholder-employees to minimize their salary to reduce their Social Security Tax exposure and in turn, increase their non-salary distribution.
“We’ve been told the IRS takes a high interest in this area. This dance of the dollars via distribution versus salary favors the taxpayer, since the monies are not subject to FICA tax or self-employment tax. While such thinking is shrewd, the reality is, the IRS will attack such a move,” said Partner Howard J. Kass.
In a C corporation scenario, the strategy reverses. Unlike S corporations, C corporations pay tax on their own income. In determining the amount of taxable income, salaries are a deductible expense, while dividend distributions are not. This is the “double taxation” issue that C corporation owners try to avoid.
So, in this scenario, while shareholder compensation should theoretically be pushed as high as reasonably possible (while remaining somewhat aligned with industry standards) to reduce the corporation’s taxable income, understand that the IRS may disallow the portion of the company’s deduction it deems to be excessive and reclassify it as a dividend. The result? A shareholder-employee would be required to report that excess salary as a taxable dividend on their tax return and the corporation would lose that excess as a tax deduction.
From the company standpoint, the rules allow a salary deduction for both a C corporation and an S corporation, but remember the amount of salary deducted must reflect “a reasonable allowance for salaries actually rendered” (IRC § 162(a)(1)) reflecting what would “ordinarily be paid for like services by like enterprises under like circumstances.” source: www.journalofaccountancy.com/issues/2009/jun/20081250.html
The next and obvious question becomes how does the IRS determine “reasonable compensation”?
Reasonable compensation is defined (by Reg. 1.162-7(b)(3)) as the amount that would ordinarily be paid for like services by like organizations in like circumstances.
Tax courts have used two tests to determine the reasonableness of compensation. The 5 Factor test and the Independent Investor test.
The 5 Factor Test
- The employee’s role in the company
What services is the employee performing for the company? Relevant considerations include the position held by the employee, hours worked, and duties performed.
- An external comparison with other companies
What do other comparable businesses pay for similar services paid to their employees in a like-titled position. Are the types of compensation similar?
- The character and condition of the company
The focus under this category may be on the company’s size as indicated by its sales, net income, or capital value. - Potential conflicts of interest
The primary issue within this category is whether some relationship exists between the taxpaying company and its employee that might permit the company to disguise nondeductible corporate distributions of income as salary expenditures. - Internal consistency of compensation
Are there variances among non-shareholder employees that would raise a flag? Does the manager, business developer, or the administrative professional receive a salary proportionate to that of the employee shareholder? Does this employee perform work beyond what is considered routine and typical? How does the nature, extent, and scope of the employees work constitute a higher wage than “reasonable” in comparison?
The Independent Investor test
This test considers whether an inactive, independent investor would be willing to compensate the employee as he was compensated.
Now that we have dissected some of the tests for determination of reasonable compensation, we can go back to the question of how to determine if a shareholder-employee has in fact been under- or overpaid. Is this a bulletproof process? Absolutely not! However, if one fastidiously builds the case for their compensation being reasonable, the chances for success in an IRS examination increase.
As you can see, setting an appropriate level of shareholder-employee compensation can be confusing and, if addressed improperly, could result in additional tax and penalties.
If you have questions about shareholder-employee compensation, your business structure, or ways in which you can minimize your tax liability, contact me at hkass@zinnerco.com or any of our professionals at info@zinnerco.com or 216.831.0733. We’re ready to start the conversation and happy to help.
