As passthrough entities, Subchapter S corporations (S corps) find themselves in a unique situation when it comes to federal taxes. The compensation payments that an S corporation makes to employee-shareholders are subject to payroll and income taxes, but this is not the case with dividend distributions. As a result, shareholders typically want to minimize their compensation payments and maximize their dividend distributions.
IRS guidelines state that S corps must make reasonable compensation payments before making non-wage distributions to prevent S corporations from disguising compensation payments as distributions.
If you are an S corporation owner, however, these guidelines may seem clear as mud. In this article, we take a better look at the factors to help you determine reasonable compensation.
The Factors Involved in Determining Compensation
No definitions or guidelines explain a reasonable compensation in the Internal Revenue Code or the Treasury Regulations. However, the courts consider several factors in determining reasonable compensation.
Training and Experience
Generally, the higher your experience, and the more extensive your skillset, the higher your salary as a shareholder-employee should be.
Duties and Responsibilities
An individual who assumes high-level responsibilities should receive higher compensation than someone with low-level or no responsibilities.
Efforts and Time Devoted to the Business
Your real contribution to an S corporation’s operations also affects the compensation you should receive. Longer working hours or a high-intensity workload warrants a higher salary.
Payments of Non-Shareholders
The salaries that non-owner employees receive is usually an accurate representation of reasonable compensation for shareholder-employees. The shareholder’s salary should be, at least, the same as the salary of the highest-paid employee. The duties, background, and responsibilities of the non-shareholder employee should be similar to those of the shareholder-employee.
Giving Bonuses to Key People
A bonus is not a distribution, but taxable compensation. The frequency, amount, and methods of bonus payments provide a point of comparison between their salary and that of employees who make a similar contribution. Bonus payments are significant in determining the reasonableness of compensation according to IRS guidelines for S corps.
What are Other Businesses Paying for Similar Services?
Another way to determine a reasonable owner-employee compensation is to consider the salaries of employees who work in companies that are similar in type and size. For this method to be effective, you have to find the average salary of several comparable positions. A compensation consultant can provide the necessary information on prevailing rates of compensation.
Agreements for Compensation
The compensation amounts in corporate resolutions or employment agreements can also accurately reflect reasonable compensation. These salary figures are worth considering if minority shareholders, independent compensation committees, or parties who have no incentive to disguise salaries as corporate distributions set them.
A Company’s Financial Conditions
The financial situation of an S corporation is significant in determining reasonable compensation. If a corporation with a sole owner recently opened for business, a reinvestment of its entire taxable income may be necessary to keep the doors open. In this case, zero compensation is reasonable.
However, if an established S corporation generates $200,000 per year, an annual compensation payment for a sole shareholder-employee of, for example, $3,000 does not meet the IRS’s criteria and is not reasonable. In this case, reasonable compensation will be more along the lines of $80,000 or higher.
History of Dividends
If an S corporation’s shareholders have a history of withdrawing dividends but no compensation, the IRS and court may view the dividends as a representation of wages that are subject to payroll and income taxes.
Evaluating Compensation for S Corp Shareholders Who Wear Multiple Hats
When evaluating reasonable compensation, it is critical to identify the responsibilities and duties of the individual in question. In many cases, the roles that an officer fulfills within an organization don’t fall under one specific job title.
You may have the title of chief executive officer, but you may also have other titles, such as a head of sales or director of corporate development. In these cases, valuation professionals have to gain a thorough understanding of your roles within the business before analyzing the compensation data and determining the reasonable compensation level.
Resources to Determine Reasonable Compensation
Information sources on compensation for comparable services include recruitment or employment agencies and the U.S. Department of Labor’s Bureau of Labor Statistics. Tax advisors can also use tools from Robert Half, salary.com, and monster.com to compare shareholder-employees’ compensation with industry norms and determine their reasonableness.
Tax advisors should also use survey reports to calculate compensation in relation to corporations’ profits or sales. The Risk Management Association’s (RMA) Annual Statement Studies and Management of Accounting Practice (MAP) feature financial ratios that allow for comparisons with companies of the same size in the same geographical location.
The RMA and MAP also make it possible to compare the compensation of an owner-employee with the entity’s profitability rather than with the compensation of other owner-employees.
As a shareholder-employee, you may be apprehensive about higher compensation and paying more payroll taxes, but this option is less time-consuming than an audit. By taking a salary, you can also fund your retirement plan. After the IRS auditor recharacterizes distributions as wages, you will no longer be able to make a deductible contribution to your retirement plan.
Additionally, if the corporation treats you as an employee rather than an owner, you may receive the same benefits as other employees.
It is critical to document shareholder-employees’ compensation in corporate minutes. There should also be a re-evaluation of shareholder-employees’ compensation in case of situation changes. For example, if you no longer fulfill a specific role, your reasonable compensation can decrease.
Being responsible for determining the reasonable compensation of an S corporation’s shareholder-employees can be a daunting prospect, especially if you are not sure how to apply the IRS’s factors.
MI Tax CPA can help. As a full-service CPA firm in Michigan, we will determine reasonable compensation and ensure that your S corporation meets the IRS’s requirements. Call us today to schedule a free consultation.