S-Corporations and the Reasonable Wage Requirement
Reasonable Compensation
The fastest way
to get audited as an S corporation is to file an 1120S with no amount showing
on Form 1120S Line 7 "Compensation of Officers." It is assumed by the
IRS that no one works for free, and so the IRS has said over and over again
that officers of the corporation must receive wages
As an
owner-employee of the S corporation, you must pay yourself a salary, and pay
payroll taxes on your salary, even if the business is losing money. You don't
have to pay yourself a high salary, but it must be a "reasonable
amount" according to the IRS. Reasonableness can be interpreted in
different ways. I would keep track of the number of hours you work for your
business, and then figure out a "reasonable" salary to pay yourself
based on the amount of time you spend.
If your
S corporation is losing money (especially in the first few years of operation),
then your losses will be exaggerated by the salary you have to pay yourself.
Thus, if your economic losses (not counting your salary) is $10,000, but you
need to pay yourself a "reasonable" salary of $10,000, then your tax
loss will be at least $20,765 ($10,000 economic loss + $10,000 salary + $765 in
employer-paid payroll taxes). In an S corporation, your tax losses will always be
greater than your economic losses, and your tax profits will always be less
than your economic profits.
What's a Reasonable Salary?
IRS Fact Sheet
2008-25 provides some guidance on how to determine the amount of wage
compensation that is reasonable for a taxpayer.
In making the determination, the IRS notes that the courts have taken
into account all facts and circumstances of each case. Some of the specific factors considered by
the courts include the following:
- The training and experience of the taxpayer
- The taxpayer’s duties and responsibilities
- The time and effort the taxpayer devotes to the business endeavor
- The draw history
- The payments made to nonshareholder employees
- The timing and manner of paying bonuses to key people in the business
- The amount of comparable pay for similar services that the taxpayer provides
- The existence of any compensation agreements
- Whether there is any formula that determines compensation
Salary is
reasonable if a non-shareholder would be willing to accept the job at the
proposed salary level.
Comparable
compensation information may be found from sources such as the U.S. Department
of Labor, employment agencies and placement offices, union administrations and
professional associations.
Note>
It is important to document the sources of information used to justify the wage
compensation amount paid to an S corporation business owner.
Generally, the
IRS will grant the S corporation a degree of latitude in setting salary
compensation for shareholder-employees. However, the salary must be paid, and
the level of salary must be appropriate.
What's an Unreasonable Salary?
Zero salary is
unreasonable. No one works for free. Salary
below minimum wage is unreasonable. You would not persuade a non-shareholder to
accept a job offering below minimum wage.
Salary far in
excess of an appropriate wage is unreasonable. Paying a million-dollar salary
when an officer in similar position would expect to make only $150,000 is also
unreasonable. Some S corporations have attempted to pay higher-than-normal salaries
as a way to increase business expenses.
Why is Officer Compensation an Audit Priority?
The IRS can
collect payroll taxes on officer compensation.
If the IRS determines the S corporation paid the shareholder an
unreasonable wage, they can recharacterize the distributions as salary and
require payment of employment taxes and penalties which can include payroll tax
penalties of up to 100% plus negligence penalties.
For example, a
CPA who incorporated his practice took a $24,000 annual salary from his S
corporation and received $220,000 in distributions which were free of
employment taxes. The IRS said that his salary was unreasonably low and that $175,000
of the distributions should be treated as wages subject to employment taxes.
The court upheld the IRS’s power to recharacterize the dividends as wages
subject to employment tax. (Watson v. United States, (DC IA 05/27/2010) 105
AFTR 2d ¶ 2010–908.)
