Many small businesses elect to file income taxes as S-Corporations. As an S-Corporation, income taxes are not paid at the corporate level as C-Corporations are, but flow to the personal tax returns of their shareholders, where taxes are reported and paid.
One of the perceived advantages of electing S-Corporation status for a business is the ability to avoid or minimize self-employment taxes on earnings or a part of earnings. How does this work? An S-Corporation shareholder may be both an Shareholder/Investor and an employee of the business. As an employee, they should be paid wages for their services, just as any other employee would be paid. The wages are subject to both income taxes and Social Security and Medicare taxes. As shareholder, they receive a Form K-1 for their portion of the profits. For the K-1 Income, the shareholder will pay income taxes, but the income is not subject to Social Security or Medicare taxes.
For this reason, S-Corporation shareholders will want most, if not all of their income, as K-1 income. Is this acceptable? Perhaps, but only if the calculation of Reasonable Compensation supports it as such. The government requires that the S-Corporation pay the shareholder/employee Reasonable Compensation for the services that they provide to the business.
What is Reasonable Compensation?
On a high level, it is compensating the shareholder for the Fair Value of the services that they provide to the S-Corporation. If the shareholder was not providing those services, what would the business pay to an outside party for the value of those services.
Some of the factors that drive “Reasonable Compensation” include:
- Duties and responsibilities of the role
- Amount of time for the role (Full-Time or Part-Time)
- Training and experience required for the job
- What comparable businesses pay for a similar role
How do you calculate a Fair Value wage for the Shareholder/Employee?
You can use outside sources such a indeed.com, salary.com or government sources to receive guidance on average pay rates, and then use those rates multiplied by the hours of service provided by the Shareholder/Employee, to craft a fair compensation arrangement.
Risks of Not Paying Reasonable Compensation
What happens if you don’t pay reasonable compensation? Sometimes nothing happens, at least for a long time. If there are NO shareholder wages paid, it is much more likely to be flagged by the IRS. However, if wages are paid, it is possible that the IRS may not flag the return, at least not immediately.
If a taxpayer is audited, they will be expected to provide support for the shareholder wages paid. Historically, shareholders have used a fixed dollar amount or a percentage of earnings to support their wages paid, but as noted above, that is not “Reasonable Compensation”. The IRS will most likely take a much more conservative view of compensation that should have been paid. This can not only create Social Security and Medicare taxes on that dollar amount, but also extensive penalties and interest. It is critical if a taxpayer goes into such an audit, that they be able to support their calculation of shareholder wages.
Do You Need Help?
Are you a Shareholder of an S-Corp, who would like to learn more about how to implement wages in a manner that minimizes risk, but does not cause you to overpay taxes? If so, I’d be happy to talk with you. Please give me a call at (972) 821-1991 or email me at bob@jablonskyandassociates.