S Corporation
Reasonable Officer Compensation
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S Corporation
Reasonable Officer Compensation
“Is it Reasonable? “
2
Learning Objectives
Upon completion of this webinar you will be able to:
• Recognize who qualifies to be an officer of an S Corporation and if they
receiving "reasonable" compensation.
• Identify the various methods that can be used to determine what is
reasonable and the consequences of unreasonable compensation.
• Determine how the government picks their labor audits.
• Identify what is unreasonable salary and what is unreasonable salary for SSA.
• Classify who is an employee.
• List nine factors used by courts.
• Identify factors used to determine compensation.
3
Eye Catching Statistics!
 In 2005 Treasury Inspector General for Tax
Administration (TIGTA) issued a report
 Analyzed S Corporation returns filed in 2000
 About 80% of all S Corps were more than 50% owned by ONE
shareholder
 Single-shareholders of S Corps paid themselves about 41.5%
of corporate profits, declined from 47.1% in 1994
Eye Catching Statistics!
 36,000 Single-shareholder of S Corps generating
over $100,000 of income too ZERO salaries,
passing through $13.2 Billion to shareholders Free
of payroll taxes
 Total payroll taxes by single-shareholder S Corps
were $5.7 Billion less than if they were taxed as
sole proprietors
Eye Catching Statistics!
 In 2009, U.S. Government Accountability Office
(GAO) reported to Senate Committee on Finance
 In 2003 & 2004 combined, S Corporations underreported
their shareholder compensation by $24.6 Billion
 The responsible corporations had fewer than Three
shareholders responsible for almost all underreporting
Reasonable Compensation
The IRS has recently indicated there will be audit initiatives
for S Corporation officer compensation
Lack of shareholder compensation on an 1120S tax return is
a major “red flag”
Andrew has already experienced it!
Rev. Rul. 74-44,1 – IRS may recharacterize dividends as
wages
7
Reasonable Compensation
S Corporation shareholders think “No Double Taxation”
means “No Payroll Taxation”
S Corporations are pass-through entities, however there
Must be reasonable compensation
Lack of officer compensation is a disaster not a savings!
8
What Is Unreasonable Salary?
Zero salary is unreasonable
Nobody works for FREE!
Salary below minimum wage is unreasonable
Salary in excess of appropriate wage is also unreasonable
9
What Is Reasonable Salary?
This is the million dollar question!
IRC states distributions and other payments to a corporate
officer for services must be treated as wages
There are no specific guidelines for reasonable
compensation, thus allowing abusive practices by S Corps
10
Taxpayers Love Unreasonable Compensation
S Corporation dividend distributions are Not subject to
Self-Employment Tax (SECA)
Not subject to Federal Unemployment Tax (FUTA)
Not subject to State Unemployment Tax (SUTA)
11
Taxpayers Love Unreasonable Compensation
 Taxpayer saves the following
 7.65% in employer portion of FICA
 7.65% in employee portion of FICA
 Federal Unemployment (FUTA)
 State Unemployment (SUTA)
Are the savings worth the risk?
IRS Loves Unreasonable Salary
IRS won’t hesitate to recharacterize distributions to
compensation
Penalty for failing to pay employment taxes is 100% of
taxes owed, and may lead to Trust Fund Penalty!
Penalties are not tax deductible
They add up quickly & IRS loves it!
13
SSA Loves Unreasonable Compensation
Social Security Administration (SSA) is concerned with S
Corp Officer Compensation
Can recharacterize dividend distributions to
compensation
Can reduce Social Security benefits
14
FS-2008-25
IRS issued Fact Sheet-2008-25 – August 2008 (Warning
for S Corporation shareholders)
FS-2008-25 reiterated the factors to be considered for
determining reasonable compensation
Outlines that corporate officers are employees for FICA,
FUTA, Federal Income Tax under the IRC
15
When Should There Be Payment?
When services are performed for the corporation; and
Shareholder receives or is entitled to receive payment;
The compensation is considered wages; and
It is taxable for federal employment taxes
16
Who Is An Employee
Shareholders are employees if they perform services
Can they perform different types of services?
Can there be different levels of compensation?
What are the determining factors for compensation?
17
9 Factors Considered by Courts
1) Training and experience
2) Duties and responsibilities
3) Time and effort devoted to the business
4) Dividend history
5) Payments to non-shareholder employees
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9 Factors Considered by Courts
6) Timing and manner of paying bonuses to key people
7) What comparable businesses pay for similar services
8) Compensation agreements
9) The use of formulas to determine compensation
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Factor 1 - Training and Experience
What type of training does shareholder-employee have?
What type of experience does shareholder-employee
have?
What level of education does shareholder-employee
have?
20
Factor 2 - Duties and Responsibilities
What type of duties does shareholder-employee have?
What is he/she responsible for? (Management, daily
operations, clerical)
How do the duties and responsibilities compare to other
employees in the business?
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Factor 3 - Time and Effort Devoted
How much time is dedicated to the business?
Is documentation available for the various duties
performed?
Is the time devoted for major or minor services?
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Factor 4 - Dividend History
Is there consistency in issuing dividend payments?
How often are dividends paid?
How much is each dividend payment?
Is there a formula used to compute dividends?
23
Factor 5 - Payments to Non-Shareholder Employees
Does business have non-shareholder employees?
What type of services do non-shareholder employees
perform?
How do they get compensated?
How often do they get compensated?
24
Factor 6 - Timing & Manner of Bonus Payments to Key Employees
Do all or some employees receive bonus payments?
If so, how often are bonuses paid?
How are they determined? Is a formula used?
Are they performance based, or position based?
25
Factor 7 - What Do Competitors Pay For Similar Services?
What do other businesses in the industry pay for similar
services?
What do other businesses in the local vicinity pay for
similar services?
How does shareholder’s compensation compare to
competitor’s and industry?
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Factor 7 - What Do Competitors Pay For Similar Services?
 Check competitor and industry compensation
regularly
 Check www.Salary.com & www.Monster.com
 Salaries and compensation change as economic
climate changes
 Would your competitor hire you for what you pay
yourself?
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Factor 8 - Compensation Agreements
Are compensation agreements used with nonshareholder employees?
Is there a compensation agreement executed by
shareholder-employee?
Does compensation agreement clearly outline duties,
responsibilities, wage compensation, and dividend
distributions?
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Factor 9 - Using Formulas To Determine Compensation
Are formulas used to compute compensation for
shareholder-employee?
Is it the “60-40” Rule?
Is the formula used consistently?
Does it provide for reasonable compensation?
29
Review Questions for Self-Study CPE
Now’s the time to answer the review questions.
Follow this link:
http://www.proprofs.com/quiz-school/story.php?title=NTc1ODky
Please leave quiz window open and wait to submit until
prompted to complete questions 4 through 6. Once completed,
press Submit and close quiz window.
Amazing Doggy Day Care Center- Case Study 1
 Fact’s for IRS S Corporation Office Compensation
audit
 Julie Jones (mother) & Amanda Jones (daughter)
owned and operated Amazing Doggy Day Care
Center, a business in Atlanta, GA from 2005-2010
 Business sold in September 2010
 Taxpayer audited by IRS for employment taxes for
tax year 2010 in 2012
Amazing Doggy Day Care Center- Case Study 1
 Amazing Doggy Day Care gross revenues in 2010 were
over $550,000
 Amazing Doggy Day Care net profit was $91,000
 Business had a staff of 20 employee’s ranging between
$8.00 to $16.00 per hour
 Julie paid herself $28,000 in officer compensation for
 Amanda paid herself $1,000 in officer compensation
Amazing Doggy Day Care Center- Case Study 1
 Can you successfully represent this taxpayer?
 What facts do you feel are a detriment to the
taxpayer?
 What facts do you feel can help the taxpayer win this
case?
 Are there other things we should look at in
preparation of this audit?
Amazing Doggy Day Care Center- Case Study 1
 Who won this examination?
 The IRS, or
 Amazing Doggy Day Care Center
Other Factors to Consider
Health and accident insurance premiums
Loans between corporation and shareholder
Expenses paid by shareholder using personal funds
Income allocation to family members
35
Health & Accident Insurance Premiums
Does business pay health & accident premiums on
behalf of greater than 2% shareholder-employee?
Is coverage in the business or shareholder’s name?
Are the payments reported on shareholder’s W-2?
36
Health & Accident Insurance Premiums
Greater than 2% shareholder premium payments
should be reported on W-2
Not taxable for FICA or FUTA taxes
Mandatory reporting on W-2 effective January 2013
37
Health & Accident Insurance Premiums
Notice 2008-1 – Revised regulations for health coverage
plans. Policy doesn’t have to be in S Corporation name
Still deductible even if health coverage is in 2%
shareholder’s name. It’s considered to be established by
S Corporation
S Corp can pay health insurance premiums or reimburse
shareholder and take deduction
38
Atlanta Data Center – Case Study 2
 Georgia Department of Labor audit conducted in 2012
on Atlanta Data Center, a service based business for
tax year 2011




Facts of the case are as follows
Atlanta Data Center has been in operating since 2000
Owned by a single-shareholder David Sanders in 2011
David Sanders sold 60% share to Tom Price a wealthy
billionaire in 2012, for $3.6 million
Atlanta Data Center – Case Study 2
 Business gross revenues in 2011 were $4.3 million
 Business net income in 2011 was $1.2 million
 David Sanders paid himself a salary of $172,000 in
2011
 He received distributions of $440,000 in 2011
 The S Corp paid for his health insurance of $14,600
 David’s percentage of salary to distributions is 28%
Atlanta Data Center – Case Study 2
 Can you successfully represent this taxpayer?
 Who is our client, David Sanders, Tom Price, or
both?
 Are there any ethical dilemmas in this case?
 What will you use to represent Atlanta Data
Center against the GA Department of Labor?
 Do we have any other concerns in this case?
Atlanta Data Center – Case Study 2
 Who won this audit?
 The Georgia Department of Labor, or
 Atlanta Data Center
Shareholder Loans
Shareholder loans are allowable
Must be repaid with Reasonable Interest
Paying interest legitimizes loan as Arms-Length
transaction
Not paying interest can be construed as Capital
Contribution
43
Shareholder Loans
Loans must be in writing – Formal Note between
corporation and shareholder
Reasonable interest must be paid
Compare interest rates from local banks to get market
rate
Interest expense is deductible for the business
44
Shareholder Loans
 No interest can be construed that debt is contingent
upon corporate profits
 Debt contingent upon corporate profits is considered a
second class of stock
 Second class of stock terminates S Corporation Election!
 Busting up S Corp turns it to C Corp – Double Taxation!
45
Expenses Paid by Personal Funds
Expenses paid with shareholder’s personal funds
should be reimbursed with company check
Expense reimbursement form should be completed for
documented expenses
Expenses charged on shareholder’s personal credit
card should be well documented
46
Income Allocation to Family Members
 Shifting S Corporation income to family member
shareholders in a lower tax bracket
 Helps reduce tax liability for shareholder
 Great for estate tax planning, but not great for
shareholder compensation issues
 IRC Section 1366(e) – Gives IRS authority to make
adjustments
47
Hobby – Loss Issues
Is there a reason why business can’t compensate
shareholder for services year after year?
Is the shareholder not getting compensated because
business is a hobby; or
Because the owner is a bad business person and can’t
turn a profit?
48
S Corporation Court Cases
 Roob vs. Commissioner (Court upheld IRS reallocation of
dividends – Taxpayer failed to present evidence salary was
reasonable)
 Rocco vs. Commissioner (Court ruled in favor of taxpayer –
Salary was reasonable even with large dividends)
 Davis vs. Commissioner (Court ruled in favor of taxpayer using
comparability test – Paid comparable salary to industry)
49
S Corporation Court Cases
 Ludeking vs. Finch (Court ruled in favor of SSA to reclassify
dividend distributions)
 Herbst vs. Finch (Court ruled in favor of taxpayer – SSA couldn’t
reclassify salary)
 Weisenfeld vs. Richardson (Court ruled minor wages were not
substantial services –SSA lost)
50
S Corporation Court Cases
 Bianchi vs. Commissioner (Court ruled compensation was
excessive – reduced pension contribution)
 Joseph Radtke vs. U.S. (Court ruled no salary was paid by
Attorney – shareholder)
 Spicer Accounting vs. U.S. (Court ruled no salary paid by
Accountant - shareholder)
51
S Corporation Court Cases
 Veterinary Surgical Consultants, P.C. vs. Commissioner
(Tax Court ruled employer can’t avoid federal taxes by
characterizing compensation paid to sole shareholder as
distributions)
 Joly vs. Commissioner (Court ruled that shareholderemployee used company bank account for personal use. Ruled
that employment taxes were owed on personal use money)
 Joseph M. Grey Public Accountant, P.C. vs.
Commissioner (Court ruled that dividends were actually wages
subject to employment taxes)
David E. Watson, P.C. - S Corporation Court Case
 David E. Watson, P.C. vs. Commissioner (Accounting
Case)
 David Watson, CPA formed David E. Watson PC (DEWPC), and
Iowa professional corporation electing to be taxed as S Corp
 Under an employment agreement with DEWPC, David provided
exclusive accounting expertise to accounting firm which he had
formerly been a partner.
David E. Watson, P.C. - S Corporation Court Case
 In 2002 & 2003, DEWPC paid Watson a salary of
$24,000 each year and distributions of $203,651 in
2002 and $175,470 in 2003.
 IRS challenged the distributions and assessed FICA
taxes, penalties, and interest. DEWPC took case to
tax court
 Who won in this case?
David E. Watson, P.C. - S Corporation Court Case
 District Court ruled against DEWPC – stated $24,000 per
year salary was “less than credible”
 It accepted the IRS recharacterizing distributions of
$91,044 to salary.
 Damaging facts were that David had 20 years
experience, was primary revenue producer for firm,
worked 35-45 hours per week, firm was wellestablished
Case Study – Sanders Corp
1)



$100,000 in W-2 Wages
Employer FICA @ 7.65%
Employee FICA @ 7.65%
Total Tax Liability
2)



$10,000 in W-2 Wages/$90,000 in Distributions
Employer FICA @ 7.65%
$765
Employee FICA @ 7.65%
$765
Total Tax Liability
$1,530
$7,650
$7,650
$15,300
56
Case Study – Sanders Corp
Tax Liability – Situation 1 $15,300
Tax Liability – Situation 2 ($1,530)
Tax Savings in Situation 2 $13,770
Which would you recommend if your client asked for advice?
57
Case Study – Jones Printing Inc
“60-40” Rule - Danny Sole Shareholder
Services provided by Danny
Profits $100,000 (Are distributed)
60% Salary - $60,000
40% Distributions - $40,000
Is this reasonable compensation?
58
Case Study – Jones Printing Inc
“60-40” Rule – Danny Sole Shareholder
Services provided by Danny
Profits $100,000 (Not Distributed)
60% Salary - $60,000
Should Danny take $60,000 salary if no earnings are
distributed?
59
Tax Implications of Reclassification
Penalties from reclassification are not deductible
Higher taxes for IRS if distributions are reclassified
Amended 1120S and 1040 will be required
Higher scrutiny if future years
60
Case Study – Home Crafters Inc
$90,000 Net Profit – No Salary Paid to Melissa
Melissa provides services to Corporation
$50,000 Distributions Paid to Melissa
Employer FICA Savings @ 7.65%
$3,825
Employer FUTA Savings @ 6.2%
$ 434
Melissa’s FICA Savings @ 7.65%
$3,825
Total Savings
$8,084
61
Case Study – Home Crafters Inc
IRS Audits and reclassifies $50,000 of distributions
Melissa received
New Net Profit to Report on 1120S after reclassification
Net Profit before Reclassification
$90,000
Less: Salary Payment
($50,000)
Less: Payroll Taxes
($4,259)
Net Profit on 1120S Post Reclassify
$35,741
62
Case Study – Home Crafters Inc
Melissa’s total income on her 1040 after reclassification
Net Profit
$35,741
Salary
$50,000
Total Income
$85,741
Assume Melissa is in 28% tax bracket. She will pay $1,193
less in income taxes ($4,259 x 28%)
63
Case Study – Home Crafters Inc
Melissa pays $1,193 less in income taxes
However, U.S. Government collects $6,891 more in
payroll taxes
Total Payroll Taxes–S Corp/Melissa
Less: Melissa’s lower income tax
Net Increase in Taxes due IRS
$8,084
($1,193)
$6,891
64
Suggestions for Reasonable Compensation
 Distributions should be recorded in corporate
minutes
 Distribution payments should be stated as a dollar
value per share owned by shareholder
 Don’t make frequent distributions (Monthly)
 Distributions paid to all shareholders on same date
65
Suggestions for Reasonable Compensation
Do Not pay personal bills through business and “call”
them distributions
Pay reasonable wages using comparable salaries with
industry and position
If business is losing money, don’t put borrowed money
into business and pay it as distributions
66
Reasonable Compensation
Always provide your client the worse case scenario
figures
Let them know in advance that it’s costly to not be
Reasonable with the IRS!
Be Reasonable – Stay Out of Trouble!
67
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