Small Business by Richard K. Murray: Filing S-Corp status could make you a target on tax return

SCORE volunteer, executive director of the Dispute Resolution Center of the Northwest and volunteer mediator/arbitrator for the BBB.August 20, 2013 

Many small business owners select S-Corp status to enjoy the benefit of “pass-through” of company profits to shareholders without incurring payroll taxes, as well as protecting personal assets from business liabilities. In this article we will look at the tax law requirements for shareholder-employees to be paid reasonable compensation.

Reasonable compensation is basically defined by the Internal Revenue Service as the compensation the company would have to pay a nonshareholder to perform the same work, or alternatively the fair market value of the services if the shareholder-employee was to sell these services to an organization other than the S-Corp. The courts have consistently upheld the IRS in these cases. Further, the IRS may reclassify any distributions, including repayment of loans, dividends, even return of basis paid to shareholder-employees as compensation subject to payroll taxes, interest and penalties. This includes both cash and noncash payments.

The Treasury Department and the Government Accounting Office have conducted a number of studies about reasonable compensation over the past several years and have found several trends. First, shareholder-employees of S-Corps pay themselves significantly less than their reasonable compensation (the latest study calculates an average underpayment of $105,000 per year per employee), and this means that payroll taxes are significantly underpaid.

IRS audits of S-Corps are increasing, but the agency is not catching the underpayment of reasonable compensation in many of these audits. So the IRS is increasing its S-Corp audits and is applying new tools to determine reasonable compensation. So if you are an S-Corp shareholder-employee, you are likely to have a target on your return.

So, what factors must you consider in establishing and documenting “reasonable compensation?” There are several factors the IRS have found critical: the gross receipts attributable to non-shareholder employees and capital equipment; shareholder services that include the direct generation of gross receipts attributable to shareholder-employees; and the value of their administrative work. Factors identified by the courts include: training and experience; duties and responsibilities; what comparable businesses pay; time and effort devoted to the business; use of a formula to determine reasonable compensation; payments to nonshareholder employees; dividend history; timing and method of bonuses; and formal compensation agreements.

That sounds simple, but since most S-Corp owners perform a lot of different tasks, from janitorial to administrative services, how is reasonable compensation calculated? One source of data is the U.S. Bureau of Labor Statistics and the median salaries for job categories in the region in which your company is located. Once you have identified all the jobs you perform for the company, the complexity is in developing the formula to allocate your time among the duties and arrive at a databased reasonable compensation.

Once you have done the research, it is advisable to formalize the compensation agreement with each shareholder-employee and document that agreement in the minutes of one of the corporation’s board meetings. The IRS or the courts will not consider using “rules of thumb” defensible if the IRS calculates a different amount for reasonable compensation.

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