May 11, 2017
S corporations are popular – the IRS estimated there were upwards of 4.6 million S corporations in existence in 2014, a figure which has been steadily increasing. Part of this popularity is because S corporations avoid the “double taxation” of C corporations by passing income through to their owners, who pay a single layer of tax. In general, distributions paid out of S corporation earnings are tax-free to the owners whenever they are paid out.
Because of this pass-through structure, S corporation owners will commonly try to minimize or avoid paying salaries to their owners essentially to avoid payroll taxes. Below is an example of a simple single-owner S corporation to illustrate this:
As you will see, increasing an owner salary generally has no net impact for income tax purposes, since the corporate pass-through income will decrease, but wage income will increase to offset this.
However, payroll taxes apply to owner salaries, which causes increases in owner salaries to have an approximate cost of 15.3% (the FICA tax rate) up to the $127,200 social security tax limit, when the FICA cost drops to 2.9%. In addition, there may be costs for state payroll taxes or worker’s compensation insurance (dependent upon state law), slightly offset by the income tax benefit for paying the payroll taxes.
Because of the substantial payroll tax cost of owner salaries, some S corporations will pay a minimal or zero salary to owners, and make all payments as shareholder distributions from corporate earnings.
While S corporations can legitimately reduce the owner’s payroll taxes as compared to other business structures such as a sole proprietorship, or a partnership – paying too little compensation is a real problem, and can be an audit flag.
The standard for the compensation that should be paid by your S corporation is “reasonable compensation”, which generally means the amount of wages that would ordinarily be paid for similar services by a similar business in similar circumstances. Or in short – it depends on your facts.
Unfortunately, there is no universal rule of thumb to determine if your S corporation compensation is “reasonable”. Consulting with your tax advisor is critical in this matter, as well as documenting in your files specifically how you have calculated the salary amount, with references to available market data (salary.com for example for comparable positions), and potential mitigating factors (for example, a business start-up generally pays lower salaries). An overall “smell test” is always helpful – if you are making $250,000 of corporate income for services that you are personally providing, and you are only paying yourself a $20,000 salary, that is almost certainly not reasonable. However, if you are a capital intensive business with $500,000 of revenue and net profit of $250,000 by manufacturing widgets, and are paying an owner salary of $100,000, that very well might be reasonable.
If you are interested in the nitty gritty of how compensation should be determined for an S corporation, below are factors developed by the legal system for calculating reasonable compensation. No single factor is decisive, and all relevant facts and circumstances should be carefully considered for relevance.
Reasonable Compensation Factors
(1) The employee's responsibilities and duties in the S corporation; the type and extent of the services rendered; the employee's qualifications, hours worked, duties performed, and his importance to the company's success;
(2) The prevailing compensation paid to an employee as compared with that paid by similar companies in similar industries for similar services;
(3) The scarcity of qualified employees, the employee's prior earning capacity, and his or her contributions to the S corporation venture;
(4) The S corporation's size as indicated by its sales or capital value, the complexities of the business, the general economic conditions, and the peculiar characteristics of the business;
(5) Whether the relationship between the S corporation and the employee whose compensation is at issue might permit the corporation to disguise compensation as shareholder distributions; and
(6) Whether the compensation is paid under a structured, formal, and consistently applied program (bonuses not paid under such plans are suspect).
There are many nuances to this issue, so please consult your tax advisor. This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation.
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