The Internal Revenue Service recently issued a fact sheet regarding shareholder-employee compensation from an S corporation. Tax advisors commonly advise S corporation shareholder-employees to pay themselves minimum compensation in the form of “wages” subject to Social Security and Medicare taxes, and take the rest of their compensation as “distributions” not subject to federal employment taxes. Remember, too, that the term “wages” includes all remuneration for employment, such as the cash value of all benefits. The fact sheet cautions that, “S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.” This is an area of serious contention between the Service and S corporation shareholders and their attorneys.
Generally, shareholder is an employee of a corporation if he or she performs more than nominal services for the corporation. The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an individual would not be considered an employee.
Instructions to the Form 1120S (U.S. Income Tax Return for an S Corporation), state, “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 obvious issue is, “What is reasonable compensation for a shareholder-employee?” Neither the Internal Revenue Code nor the Treasury regulations define the term. Various courts have defined “reasonable compensation” based on the facts and circumstances of each case, based on some of the facts below:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- 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
Under current law, wages of less than $106,800 coupled with high distributions will certainly raise “reasonable comp” questions with the Service. That amount is the FICA limit in 2009 subject to the 12.4 social security tax; amounts above that are only subject to the 2.9 percent health insurance tax. This amount should not be considered a “safe harbor,” however.
The fact sheet also addressed treatment of medical insurance premiums paid on behalf of (or reimbursed to) shareholder/employees. It states that “The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security, Medicare, or Unemployment taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2. Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2.”
All of this may change, however. There is some thought of making S corporation “distributions” subject to self-employment taxes in the same manner as a partnership. While that may cure the problem, the barrier to such legislation is the fact that corporations (including S corporations) are legal entities separate from their owners. I’ll be watching for developments in this area as tax legislation emerges from a new Congress.
If you have questions concerning tax treatment of compensation to owners of S corporations, partnerships, or LLCs, call me at 214.957.3366 or email me.
Ronnie
Copyright 2008 Ronnie C. McClure, PhD, CPA
