s corporation reasonable officer compensation

S Corporation Reasonable Officer Compensation

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S Corporation Reasonable Officer Compensation

“Is it Reasonable? “

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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.

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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


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


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

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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!

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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

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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

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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)

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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!

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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

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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

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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

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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?

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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?

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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?

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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?

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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?

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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 non-shareholder 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?

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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.

http://www.proprofs.com/quiz-school/story.php?title=NTc1ODky


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 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


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?


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

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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?

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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

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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

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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


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%


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?


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

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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

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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!

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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

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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

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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?

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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)

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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)

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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)

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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 shareholder-employee 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.


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?


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 well-established

Case Study – Sanders Corp

1) $100,000 in W-2 Wages Employer FICA @ 7.65% $7,650 Employee FICA @ 7.65% $7,650 Total Tax Liability $15,300

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

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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?

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Case Study – Jones Printing Inc

“60-40” Rule - Danny Sole Shareholder Services provided by Danny Profits $100,000 (Are distributed)60% Salary - $60,00040% Distributions - $40,000

Is this reasonable compensation?

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Case Study – Jones Printing Inc

“60-40” Rule – Danny Sole Shareholder Services provided by DannyProfits $100,000 (Not Distributed)60% Salary - $60,000

Should Danny take $60,000 salary if no earnings are distributed?

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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

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Case Study – Home Crafters Inc

$90,000 Net Profit – No Salary Paid to Melissa Melissa provides services to Corporation$50,000 Distributions Paid to MelissaEmployer FICA Savings @ 7.65% $3,825Employer FUTA Savings @ 6.2% $ 434Melissa’s FICA Savings @ 7.65% $3,825 Total Savings $8,084

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IRS Audits and reclassifies $50,000 of distributions Melissa received

New Net Profit to Report on 1120S after reclassification Net Profit before Reclassification $90,000Less: Salary Payment ($50,000) Less: Payroll Taxes ($4,259) Net Profit on 1120S Post Reclassify $35,741

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Melissa’s total income on her 1040 after reclassification Net Profit $35,741Salary $50,000Total Income $85,741

Assume Melissa is in 28% tax bracket. She will pay $1,193 less in income taxes ($4,259 x 28%)

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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 $8,084Less: Melissa’s lower income tax ($1,193)Net Increase in Taxes due IRS $6,891

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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

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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

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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!

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Review Questions for Self-Study CPE

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