Tax Article - IRS Turns Wary on S Corporations’ Compensation

Target Audience: Small Business Owners, Financial Managers, Pass-Through Entities, Trends in Compensation, Payment Models Interest, Compensation

Another compensation issue making the rounds of late is increased IRS attention to precisely how S corporations are paying their shareholder-employees.

The IRS is attacking shareholder compensation that could be too low. Unreasonably low compensation avoids social security tax. As it stands currently, net income is passed through to shareholders, who are taxed at their ordinary-income rates. The S corporation income isn’t subject to Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes, nor are shareholder-employees’ distributions subject to employment tax.

Given the potential employment tax savings, many S corporation owners are tempted to pay their shareholder-employees small salaries or none at all. Yet doing so doesn’t sit well with the IRS. The agency is targeting shareholder-employees with salaries it deems unreasonably low in an attempt to reclassify some or all of their distributions as wages. If successful in such an effort, the IRS can demand unpaid FICA and FUTA taxes, plus penalties and interest, from the S corporation in question.

Although there’s no way to “audit proof” an S corporation’s salary structure, there are relevant factors to consider in trying to minimize the risks of an IRS challenge. These include whether a given salary seems reasonable in light of the shareholder-employee’s role in the company (position, duties); how the salary compares with salaries paid by similar companies for similar services; and your company’s size, growth history and financial condition.

If your company is structured as an S corporation and you haven’t considered this issue, the time to do so is now. It’s much easier to defend a clearly thought out shareholder-employee salary structure than one that has evolved haphazardly over time with no clear oversight.

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