S corporations that employ shareholders among their workforce face some additional challenges when determining whether amounts paid to those individuals are salary expenses, which are subject to employment taxes, or distributions, which have a lighter tax impact on the business and the shareholder. The additional tax impacts of wage income on the business and the employee frequently lead S corporations to favor distributions as much as possible in an effort to minimize payroll taxes. Employers and employees each pay 6.2% of wages to Social Security (up to an annual wage base limit), and 1.45% each for Medicare. On top of that, higher-income taxpayers pay an additional 0.9% in Medicare tax on wages and salaries in excess of $200,000 ($250,000 for joint filers or $125,000 for separate filers).
S corporations that misclassify payments could be hit with costly time-consuming audits, as well as unexpected tax liabilities, penalties and interest charges. Executives should review the salaries of S corporation shareholder-employees to make sure they will hold up as “reasonable” in the event that they are questioned by the IRS.
The benefits of S corp distribution treatment
S corporations have remained a highly popular entity choice for businesses. Their numbers have continued to grow since Congress relaxed the requirements for electing S corporation status in 2004. Much of this growth has been fueled by the fact that S corporation earnings are generally not subject to double taxation as they pass through the income or loss of the business to the tax returns of shareholders. This often results in a lower overall tax rate compared to C corporations where income is taxed once at the entity level and again when it’s distributed to shareholders as dividends.
In many ways, S corporations offer private business owners the best of both worlds. Like C corporations, they provide limited liability and an unlimited corporate lifespan. Much like partnerships and proprietorships, S corporations are flow-through entities for federal income tax purposes, which means income is generally taxed only once — at the individual shareholder level.
The introduction of the 20% qualified business income deduction (QBID) in 2018 has helped to reduce the disparity between the tax rates applicable to income from the two types of corporate entities. The top C corporation tax rate is only 21%, compared to the top individual rate at 37%. The QBID can lower the effective rate that individuals pay on flow-through business income to below 30%, and, given the specific facts and circumstances of many taxpayers, S corporation distributions instead of compensation payments can result in an even lower overall tax impact at the shareholder level.
For instance, when paying shareholders who also work for the business as employees, an S corporation has some flexibility to classify those payments as either salary expense or distributions. Classification of the payments as salary expense lowers the taxable income of the business that flows through to all of the shareholders. However, salary payments are subject to payroll taxes that make them a less attractive alternative to the shareholder-employees.
On the other hand, classification of payments as S corporation distributions doesn’t reduce the taxable income that flows through to all shareholders, but it results in payments that are payroll tax-free for shareholder-employees. This outcome keeps the IRS on the lookout for combinations of wages and distributions that weigh heavily on the distribution side because the government collects less on FICA and Federal Unemployment Tax Act (FUTA) taxes.
IRS audits of S corporations will often look closely at wage and distribution structures for shareholder-employees and seek to recoup forgone payroll taxes when they determine that a business has understated reasonable salaries for shareholder-employees. The IRS looks for various red flags, including the absence of an S corporation owners’ compensation expense and an inconsistent salary and distribution history.
Supporting “reasonable compensation” for S corps
One of the challenges for any S corporation attempting to justify the reasonableness of wages paid to shareholder-employees is the ambiguity surrounding the term “reasonable compensation.” The key for an S corporation in this situation is to maintain thorough documentation that supports its classification of shareholder-employee payments throughout the decision-making process, so that it can be used to back up the allocations in the event of an IRS examination.
Estimates should always be customized for the specific facts and circumstances of each company and its unique shareholder factors, including:
- Size and location. Large, profitable firms can often afford to pay more than smaller firms. Yet smaller firms may need to pay more to attract talent. Geographic location also may affect salaries. For instance, large urban job markets generally are more lucrative.
- Corporate compensation policy. Savvy taxpayers formally document the duties and responsibilities of all employees and compare the amounts competitors pay for similar jobs. This is a company-specific factor, as the protocol for paying employees varies.
- Economic conditions. Companies pay higher salaries when the economy is thriving and cut back in leaner times. A tight labor market might necessitate salary increases to retain key employees.
- Employee qualifications. Education, professional training, reputation, industry know-how, and average weekly workload all contribute to an executive’s worth.
- Corporate loan guarantees also demonstrate an owner’s contribution to a corporation.
- An S corporation also might estimate reasonable compensation by considering the rate of return an independent investor would expect from the business. By reviewing dividends and capital appreciation, you can quantify reasonable distributions rather than reasonable compensation.
Identifying risk in S corp compensation plans
To assess an S corporation’s audit risk in this area, compare the amounts reported for distributions and compensation. Would they appear reasonable to an outsider? For payments that seem likely to raise suspicion, consider the list of unique factors in the section above, and any other unusual circumstances that might apply to the business. This area of tax law generally has no absolute “safe harbor” provisions that provide bright-line steps an S corporation can take to make certain that its allocations between wages and distributions won’t be questioned by the IRS.
The risks of misclassification also exist on both sides of the process. Penalties and additional taxes can apply both in instances where payments to shareholder-employees aren’t allocated sufficiently to compensation, and there are consequences if the balance weighs too heavily on the side of distribution treatment.
If the IRS finds that an S corporation has failed to properly classify some portion of payments as compensation, the business (and, in some cases, the shareholder-employee) can be penalized for a variety of infractions including:
- Underpayment of payroll taxes.
- Loss of benefits tied to compensation like retirement contributions and disability coverage.
- Disguised gifts (e.g., in situations where parents take lower salary to distribute more cash to their children who are shareholders).
If the IRS determines that the balance of distributions overclassified some distributions as wages, penalties could apply for violations of “disguised distribution rules.” The IRS could rule that the S corporation in effect created a second class of stock in violation of the S corporation limitations and the Subchapter S election at the core of the business could be revoked. Other activities can also put the business at risk for violating “disguised distributions rules,” such as shareholder loans, corporate payments of personal expenses, or in-kind asset distributions.
Passing muster with the IRS
Unfortunately, there’s no way to guarantee that an S corporation’s distributions and salary structure will pass muster with the IRS. But businesses that research and document their good-faith efforts to strike a balance between reasonable salaries and S corporation distributions for shareholder-employees are much more likely to see the IRS defer to their judgment.
