(Un)Reasonable Compensation and S Corporations
by Stephen D. Kirkland
Not yet a CCQ topic – look for the subject to be addressed in a 2014 issue – this article was submitted by Stephen D. Kirkland, CPA, CMC, CFC, CFF
When shareholders take funds out of their S corporations, they need to carefully classify each transfer as either compensation for services rendered or a distribution.
Many S corporation shareholders try to take distributions but not compensation, since only compensation is subject to payroll taxes and withholding.
The Internal Revenue Service may examine these corporations and make what is referred to as a re-determination of worker classification. This means that the IRS informs the corporation that they have determined that a shareholder should have been classified as the corporation’s employee for federal employment tax purposes. As a result, the IRS will assess liabilities for Federal Insurance Contributions Act (FICA) taxes, plus interest and penalties. If they disagree, these shareholders need to be well prepared to respond to the IRS’s re-determination. The taxpayers bear the burden of proof.
Background
An S corporation is usually a calendar-year taxpayer that files Form 1120S. The corporation may own equipment or investments and/or operate a business.
There are thousands of S corporations in the United States. Some individuals own multiple S corporations. At many of them, the shareholders are responsible for operational and financial decisions and may perform all of the work necessary to run the business or to manage the corporation’s assets. If the corporations take the position that the shareholders are not employees, and there are no other employees, the corporations may not bother to file IRS Form 941, Employer’s Quarterly Federal Tax Return, each quarter. In addition, the companies may not see a need to issue Forms W-2, Wage and Tax Statements, or Forms 1099-MISC, Miscellaneous Income, to the shareholders. However, showing little or no officer compensation expense on page one of Form 1120S can be a red flag. The IRS routinely conducts employment tax audits of S corporations for this reason. A company may disagree with the auditor’s redetermination, and if no agreement can be reached at appeals, the U.S. Tax Court may be asked to decide whether the IRS’s determination of worker classification is correct and to decide the proper amount of employment tax, including additions to tax and penalties. This is an expensive and time-consuming process.
Employment Taxes
Internal Revenue Code Sections 3101 and 3111 impose FICA taxes on wages received with respect to employment. The FICA tax comprises a 12.4% Social Security tax and a 2.9% Medicare tax. This Social Security tax applies to wages up to an annual limit and the Medicare tax applies to all wages. One half of the FICA tax is imposed on the employer, by Section 3111, and the other half on the employee, by Section 3101. An additional 0.9% Medicare surtax now applies to wages above certain levels. Section 3102(a) requires an employer to withhold from wages the amount of the tax imposed on its employee. Section 3102(b) says the employer is liable for remitting the tax it is required to withhold.
For employment tax purposes, Section 3121(a) defines wages as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash,” with certain exceptions. Regardless of how an employer characterizes payments made to a shareholder, the critical fact is whether a payment is actually received as remuneration for employment. Therefore, an employer cannot avoid employment taxes by characterizing payments to its shareholder as dividends, rather than wages, if such payments are for services rendered. See Section 31.3121(a)-1(c), Employment Tax Regulations. An officer who performs more than minor services for a corporation and who receives compensation in any form for those services is considered an employee, and his or her wages are subject to employment taxes. See Section 3121(d)(1) and Section 31.3121(d)-1(b), Employment Tax Regulations.
What Should S Corporation Shareholders do Before the IRS Audit?
First, maintain written logs showing what services were provided and how much time was spent on each duty. Yes, this on-going documentation is required, even as unrealistic as it may seem. Neither the IRS nor the Tax Court will accept an after-the-fact guesstimate or a verbal explanation. The records should show specific services that the shareholder performed and how much time was devoted to each duty. These records must be reliable and persuasive. Shareholders do not like the burden of keeping contemporaneous logs of their activities but this documentation will be critical in an audit. The logs may be in the form of calendars, spreadsheets or written narratives. In addition, corroborating evidence substantiating the shareholder’s logs is required. Corroborating evidence should include letters, emails and other written evidence that shows whether services were performed by a shareholder or by someone else. Also, keep in mind that IRS auditors will look for conflicting evidence, such as office hours posted on the business’ website, titles on business cards and the occupation shown beside the shareholder’s signature on page two of Form 1040.
Second, pay a reasonable salary to each shareholder who provides meaningful services. Paying some payroll taxes is better than being audited. Also, remember that by taking a salary, a shareholder can fund a retirement plan. On the other hand, once the IRS auditor has re-classed distributions as wages, it is too late for the worker to use that earned income to make a deductible contribution to a retirement plan. Reasonableness of compensation is determined by all the facts and circumstances. Primary factors affecting the reasonableness of compensation usually include the employee’s role in the company, his or her education and experience, the character and condition of the company and potential conflicts of interest. Another important factor is amounts paid by similar companies for similar services, which is known as comparability data.
Third, ensure that the correct business activity is shown on page two of Form 1120S. The nature of the business activity may lead the IRS to make assumptions about how much officers should be paid. For example, a corporation that simply owns vacant land may not be expected to pay compensation. But it could be a red flag for a corporation to indicate that it operates a construction business while officer compensation expense on page one of Form 1120S is $0.00.
Fourth, the shareholders should be careful to not take conflicting positions with respect to different areas of the tax law. For example, it might be hard to explain why a shareholder earned little or no compensation when he treated his S corporation interest as being active (not a passive activity) under Code Section 469.
Fifth, be careful with titles. In family-owned businesses, it is common to give glamorous titles to family members who do not play key roles in the business. The thinking is that a shareholder who is going to receive little or no compensation may be satisfied instead with a big title. At first glance, this seems like a harmless practice. However, the IRS may use those titles when obtaining comparability data. When comparing someone’s pay to those in the same industry with the same title, the IRS may conclude that that shareholder was under-paid. An adjustment to one shareholder’s pay may result in distributions for that period becoming disproportionate. Since S corporations are required to make distributions to shareholders on a pro rata basis (based on stock ownership) an increase in one’s pay, with a corresponding decrease in that shareholder’s distributions, can create disproportionate distributions. In a severe case, such disproportionate distributions could terminate the company’s S status.
Sixth, be careful in selecting officers for the corporation. The IRS believes that all corporate officers are employees of the corporation.
What Should S Corporation Shareholders do During an IRS Audit?
The company may contend that re-characterizing distributions from the corporation to the shareholder as wages would create unreasonable compensation to him or her. Yet, if a shareholder wants to justify receiving little or no compensation, it can be difficult to prove that he or she did no work, or performed only minimal and undemanding duties for which no training or special skills were required. But there are a few steps that could help.
First, maintain credibility in all dealings with IRS officials. Be cooperative, provide reliable information and do not let emotions override common sense and professional advice.
Second, shareholders should be careful when telling IRS auditors what they accomplished. Some individuals have boasted about all they had done before realizing that compensation would be an issue.
Third, provide compensation comparability data. This data can be internal or external. Internal data includes evidence that the S corporation paid an unrelated non-owner a similar amount for providing similar services. External data may come from a survey or database which has compiled actual compensation amounts paid by other companies, preferably in the same industry and the same geographic location. The salary information must be reliable so don’t bank on whatever can be found quickly on-line. The positions for which you provide comparability data must be sufficiently analogous to the shareholder’s position within his company. The shareholder’s role in the business, however, may be more substantial than any one typical position. Owners often do “whatever needs to be done” and work with more passion than non-owners. However, it may not be necessary for a shareholder to be paid within the range of comparability data. But be well prepared to explain why he or she was paid amounts outside the range and have documentation to support that position.
Fourth, remember that compensation amounts determined by arm’s length negotiations among shareholders may be considered to be reasonable based on an agreement among parties with adversarial interests. In Allen L. Davis, et al v. Commissioner of Internal Revenue, T.C. Memo 2011-286, the Tax Court considered an unusual set of facts. Mr. Davis and his two adult sons were shareholders of an extremely profitable S corporation but there was strife and litigation among the family members. When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense. The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis’ sons had agreed to the option grant and they had interests that were adversarial to those of their own father.
The Davis ruling is distinguished because the court did not rely on the usual factors, comparability data or the hypothetical investor test. Instead, Judge Kroupa decided that Mr. Davis’ compensation amount must have been reasonable since the other shareholders had agreed to it when the option was granted. The opinion states, “The granting of the Allen Option was reasonable because it was not a one-sided bargain.” In effect, the court relied on the other shareholders to determine whether the compensation was reasonable. In May 2013, the Eleventh Circuit affirmed the Tax Court’s decision in Davis, allowing the company to deduct the $37 million and requiring Allen Davis to report that same amount of compensation income.
Penalties
An S corporation faces stiff penalties if it fails to report compensation. First, Section 6651(a)(1) imposes a penalty for failure to file Form 941 for each quarter unless such failure is due to reasonable cause and not due to willful neglect. The penalty is 5% of the amount of the tax required to be shown on the delinquent return for each month or fraction thereof during which the return remains delinquent, up to a maximum of 25%.
Tip: An S corporation should consider filing Form 941 each quarter, even though it may not have paid any wages. Then, in the event of a re-determination, the company can at least avoid the penalty for failing to file payroll returns.
Second, the IRS may determine that the company is liable for a penalty under Section 6656 for failure to deposit the requisite amount of tax withholding for each quarter. This penalty is equal to 10% of the underpayment. To avoid this penalty, the company must show that such failure was due to reasonable cause and not willful neglect. Finally, an additional penalty may be imposed for failure to issue a Form W-2.
Please Note
This article provides a brief overview of a complex subject. This information is provided only to encourage meaningful discussion and is not intended to be legal advice or tax advice for any specific party. The tax laws change often. Please seek professional advice before making any final decisions. As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
Stephen D. Kirkland, CPA, CMC, CFC, CFF is a compensation and tax consultant with Atlantic Executive Consulting Group, LLC. He serves as an expert witness in U.S. Tax Court and other courts on issues involving potentially unreasonable compensation. He can be reached through www.ReasonableComp.biz.