August 12, 2011
Donald Paris, CPA
So you have an entity that has elected S Corporation status for tax purposes. This could be a corporation, a partnership or a Limited Liability Company (LLC). PS, if you have not already elected S corporation status, you may want to. It just might save you on taxes.
Anyway, back to the issue. You have elected S Corporation status as an attempt to lower your taxes. Great idea, but there is one area all business folks need to deal with, i.e. reasonable compensation. With a regular "C" corporation, the IRS is concerned that you have classified too much salary and not enough as dividends. With an S corporation, the IRS is concerned about the opposite. They want you to classify as much as you can as salary and as little as possible as an S distribution. This is because S distributions of operating income do not incur payroll taxes (remember Social Security and Medicare?). Sure they incur income tax, but many folks do not claim these payments as salary, and thus lower their tax by the payroll tax (between the employer and employee that tax can be 15%).
Sounds like a cool idea, right? To a certain extent, it is cool, and actually will work. However, you have to be really careful. The IRS has spent a lot of time and resources on this issue, and you don’t want to have to deal with them on this, as it will be time consuming and painful. If the IRS is right and you classified too little as salary/too much as distribution, they will reclassify some (if not all) as salary and send you a bill for the unpaid payroll tax and penalties (they will throw a few at you) and interest that is due.
So, how much is too much or too little compensation? If you ask the IRS, they will lead you to a Fact Sheet 2008-25 which was issued in August 2008 (www.irs.gov.newsroom/article/0,,id=200293,00.html). You will be interested to note that the IRS says there are no specific guidelines for reasonable compensation within the Internal Revenue Code or regulations and that each case is different based on the independent factors as well as the specific nature of the case. However, this Fact Sheet does state that S corporations should treat payments for services to officers as wages and not as distributions of cash and property, unless they perform no or minimal services. The Fact Sheet delineates 9 factors to look at in determining the answer to the question, including training, duties, time and effort spent, dividends history and payments to comparable businesses for similar services.
Are you sufficiently confused? Well, join the club. Essentially, there are no specific numbers that I or any tax professional can give you as to the correct amount. Beware of any tax professional who quotes you a number. There are lots of cases on this issue, and because every case is different, there is no one correct answer. So, the only advice I can give you is to meet with your tax professional and discuss this issue. Make sure that you and your advisor are well versed on this question and make an educated decision that you will be happy with and can defend in the event that our friends at the IRS come knocking on your door. You should also make sure that your tax professional will be willing to defend your decision in the event that you are visited. If they are not capable of helping you defend the case, you probably should find one who is.