S Corporations have been popularized as a way to structure a small business because of the many advantages it once held to avoid certain types of taxes at the end of the year. The shareholder-employees of a pass-through entity, that defines an S corporation, could once navigate the vague terminology written in the tax law to lessen their payroll tax liability as well as dodge the self-employment tax. In previous years minimizing one’s compensation in favor of shareholder distributions was considered savvy in order to minimize payroll taxes. However, in the past few years, tax court precedents have been set that more clearly defines what reasonable compensation means, eliminating the ability to shirk tax liability through the shelter of an S corp business structure.
An advantage of structuring your business as an S Corporation is not having to pay entity-level tax on the company's taxable income. Attributes and income are instead distributed among the shareholders. Those individuals then pay personal income taxes on these reported items. This sheds light on the tax advantage over sole proprietorships, partnerships and LLCs. Unallocated shares of the corporation’s income aren’t treated as self-employment income. The other business structures would be liable for paying self-employment taxes. Employers and employees currently have to split 12.4% social security tax up a certain amount and 2.9% in medicare on all wages, without limitation. Self-Employed individuals are responsible for the full amount. S Corporation income is not at risk of the self-employment tax. There is also great incentive for shareholders to prefer distributions over compensation, as distributions are not held to payroll taxes, either.
However, no longer can a shareholder-employee evade payroll taxes by eschewing “reasonable” compensation. Until recently it was left unclear what exactly reasonable meant and there was little guidance in how to prescribe a shareholder-employee’s salary. Many methods have been used, some avoiding a salary in favor of distributions entirely, others have opted to disguise compensation as independent contractor fees and most popularly, under-compensation. The IRS is now aware of these liability evading methods and have more clearly set compensation guidelines.
In three court rulings over the past three years, the IRS has been building road blocks for those S Corporations trying to eschew their tax responsibility in these ways. In one case, it was ruled that shareholders/employees who provide eminent services for a company may not take distributions in place of compensation. In another case, a shareholder’s compensation was way below the industry average especially when taking into consideration his years of experience and level of education. Independent contractor fees have been annexed from creative compensation options as well. A court did rule, however, against the IRS in one of these claims dealing with S Corporations in which a shareholder took distributions in lieu of salary, but was able to justify it because of his minimal contribution to the company.
Three determining factors in reasonable compensation has come out of these various rulings. First is the performance of the employee; how much they contribute to the revenue of their business. It is no mystery why professional fields such as law, accounting and real estate have set these precedents, because company profit is highly based on personal performance. Salary comparisons within professional fields. Based on region and firm size, a shareholder/employee should be making within a certain pay scale. That pay scale can also be determined by company conditions. If the business has excess capital not being used for expansion or reinvestment, that is a red-flag for the IRS. Other company’s not in danger of this scrutiny would be where profit is based on capital and assets like in manufacturing and distributing. In this arena, individual performance does not necessarily effect revenue.
S corporations still hold their lustre as a tax saving business structure, it is just important to follow these guidelines in determining compensation so as to not raise any red flags. There are also strategies in avoiding a large tax bill at the end of the year. To be continued...
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