Subchapter S corporations offer a number of tax advantages, but they can also lead to complications. One longstanding concern is the question of “reasonable compensation” for S corporation shareholders who are also officers or employees of the company. Several provisions in the 2017 Tax Cuts and Jobs Act (TCJA) have drawn added attention to this issue—and to the sizable penalties that companies can incur if they do not manage officer compensation properly.

Employment Taxes in Pass-Through Entities

Pass-through entities such as partnerships and S corporations do not pay federal income tax directly. Instead, they pass their income, deductions, and gains or losses through to their owners, who then report them on their personal tax returns where they are taxed at individual rates.

In S corporations, most shareholders are also officers and employees of the business. In such cases, federal employment taxes—Social Security, Medicare, and federal unemployment taxes—are collected on the salaries these shareholder-employees earn but not on any corporate earnings that are passed through to them.

To reduce their payroll tax liability, S corporation officers could be tempted to pay themselves very small salaries—or no salary at all—and instead take most or all of their earnings in the form of shareholder distributions. As appealing as it may be, however, this practice can cause major tax problems.

The Internal Revenue Code definition of “employee” specifically includes corporate officers. The instructions for the S corporation tax return (Form 1120-S) explicitly state that distributions and other payments to S corporation officers “must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

In other words, S corporations must first pay “reasonable compensation” to their shareholder-employees before making nonwage distributions to them.

What’s Reasonable? Nine Factors to Consider

The critical question, then, is how much is “reasonable compensation” for the services that corporate officers render? Some practitioners recommend S corporations report a minimum percentage of their officers’ total payments as wages to avoid raising red flags. Although the IRS does compare the amounts paid as salary with the amounts paid as distributions, there is no magic percentage that will avert further scrutiny—every company’s situation is unique.

To provide some limited guidance, the IRS has published a list of nine specific factors that various tax courts have considered in deciding cases where compensation for S corporation officers was questioned. These factors (which can be found in an IRS fact sheet at https://www.irs.gov/pub/irs-news/fs-08-25.pdf) are as follows:

• The officer’s duties and responsibilities
• Time and effort the officer devotes to the business
• The officer’s training and experience
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• The company’s dividend history
• What comparable businesses pay for similar services
• Any written compensation agreements
• The use of a formula to determine compensation

The more of these factors you can use to argue in your favor, the better your chances of convincing the IRS or a tax court that your officers’ compensation is reasonable and that you are not using S corporation earnings distributions to illegally avoid Social Security, Medicare, or unemployment taxes.

The consequences of failing an audit for reasonable officer compensation can be quite costly. If it chooses to do so, the IRS has the authority to reclassify all payments to shareholder-employees as wages. This could generate a substantial payroll tax liability plus penalties and interest.

Under a special rule, fringe benefits—particularly health insurance premiums the corporation pays on behalf of shareholders—are also regarded as compensation. Such premiums are reportable as wages for income tax withholding purposes on the shareholder’s Form W-2. They are not subject to Social Security, Medicare, or federal unemployment taxes, however. If a shareholder/employee is receiving only fringe benefits and no wages, this could be another potential red flag that attracts IRS attention.

The TCJA and Officer Compensation

Two features of the TCJA relate to the issue of reasonable compensation. The law’s 20 percent qualified business income (QBI) deduction could further persuade officers to lower their salaries to gain larger deductions. On the other hand, the QBI deduction is limited by caps based on total salaries, which could counteract the incentive. In either case, the QBI deduction further complicates compensation decisions.

Since the TCJA was passed, 30 states have enacted some form of elective pass-through entity tax to work around the law’s limit on itemized deductions for state and local taxes. These provisions have led many owners to consider restructuring their businesses as S corporations. In such cases, officers should carefully think through reasonable compensation issues in their decision.

In addition to the fact sheet mentioned earlier, the IRS offers several other publications to help companies address reasonable compensation questions. These can be found at https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-employees-shareholders-and-corporate-officers and https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues.

Please reach out to Holbrook & Manter with any questions you may have. We would be happy to assist you.