S Corp Reasonable Compensation

From Bob Jennings at TaxSpeaker. Check out TaxSpeaker at taxspeaker.com

The 2017 TCJA added even more pressure for a shareholder to minimize salary payments out of an S corporation because the 20% QBI deduction is calculated using profit after shareholder wages.

The shareholder wants to minimize wage payments and maximize profit distributions because:

1. FICA tax savings

2. Worker’s compensation savings

3. Avoidance of the .9% Medicare surtax on wage income >$200,000

4. Increase income eligible for the 20% QBI deduction

On the other hand, the shareholder wants to maximize wages because:

1. Maximize retirement plan contributions

2. Pay reasonable compensation to avoid IRS issues

3. Earn Social Security benefits

The IRS’s position

S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly. The amount of Reasonable Compensation actually paid is tied to distributions, not profit or loss.

The instructions to the Form 1120-S, 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."

It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S corporation owner is taking money (e.g. a distribution or other items of value) out of the S corporation.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take reasonable compensation plus a distribution, just reasonable compensation, or neither. What the shareholder-employee can’t do is take a distribution instead of reasonable compensation.

Keep in mind the following:

• Reasonable Compensation is defined by the IRS as: “The value that would ordinarily be paid for like services by like enterprises under like circumstances” or the hypothetical “Replacement Cost” of the shareholder-employee.

• Reasonable Compensation is based on the value of services provided (Hypothetical Replacement Cost), not profit, distributions or the amount the company can afford to pay.

• Wages (Reasonable Compensation) should be paid BEFORE distributions are made.

•  A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.

• A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation (distribution), and play ‘catch up’ in a later year.

Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business.

Anything that compensates the S corporation owner can be re-characterized as wages, including personal expenses paid by the S corporation or loans to the S corporation owner.  At the end of the day, distribution of any kind triggers the requirement to pay reasonable compensation for services provided. The best practice is to know what the value of those services is and pay that amount in reasonable compensation before taking a post-wages distribution of any kind.

Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.

Summary

Clearly, a working shareholder must pay themselves a reasonable salary. After analyzing the IRS 9 factor test in their fact sheet and the nature of the business itself, the tax professional may wish to consider industry sources such as RMA details, or even utilize an outside, expert source for the determination.

A non-working shareholder does not need, nor are they required to pay themselves a salary under Reg. §31.3121(d), and a shareholder that draws neither a salary nor a distribution is also not required to draw a wage, based on the fact sheet quote above.

IRS Fact Sheet 2008-25 includes two very important statements:

We have always recommended against short-sighted decisions to avoid Social Security tax and offer these suggestions. Because the top of the 2nd bend point of Social Security that returns the best investment on the cost of the tax is a bit above $75,000, we recommend that clients making less than $75,000 should pay a wage equal to profits. For clients earning more than $75,000, we recommend an annual $75,000 salary as a minimum base. For clients earning in excess of $160,000, we recommend a FICA wage cap minimum base. These amounts have no basis in court decisions or reasonableness, but they have practical basis for benefits at retirement and for reduced audit exposure. For those professionals arguing that paying this much costs too much in tax, and that the tax savings will be invested by their client for retirement, disability and medical coverage for the business owner, the owner’s spouse and the owner’s children (the benefits of Social Security), we ask how many clients you have had that actually save that money? A short-term decision to save tax has generational impact on clients and extraordinary long-term liability for the tax professional.

According to a 2014 internal IRS guide “Reasonable Compensation:

Job Aid for IRS Valuation Professionals ("Job Aid"),” reasonable compensation levels are typically analyzed by the market approach, the income approach, and the cost approach. The market approach is the most commonly used and is generally favored by courts, the Job Aid states.

There are no safe harbor amounts or percentages. Reasonable compensation must be consistent, determined using IRS guidelines, reasonable and supportable and documented in Board Meeting Minutes how the amount was reached.

Steps to reach a replacement cost or FMV figure 

1. Make a complete list of all the services the shareholder provides to the S corporation

2.  Apportion time among all the services listed

3. Rate shareholder’s level of expertise and experience for each service performed

4. Gather wage data on all the services listed and at the appropriate level of expertise

5. Assemble all research and data and calculate the applicable reasonable compensation figure