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September 2008 S Corporations and Employee-Shareholder Pay Abuses by entities that fail to pay reasonable compensation to owner-employees may prompt federal efforts to tighten the rules For many small businesses, it seems clear that S corporations (and LLCs that elect to be taxed as an S corporation) are the entity of choice. Even though the tax law now allows up to 100 shareholders in an S corporation, recent IRS statistics indicate that 84% of S corporation entities have only one or two shareholders. In fact, the number of S corporations with 11 or more shareholders is a mere 1% of the total S corporation filings. An S corporation, unlike a C (or “regular”) corporation, does not separately pay tax; its income or loss flows through to the shareholders. Each shareholder’s share of the income or loss is reported on a Schedule K-1 and is included in the taxable income of the shareholder as reported on his or her Form 1040. Self-employment tax. An attractive feature of an S corporation is that its net earnings are not subject to self-employment tax, an advantage that gives rise to possible tax abuse. An individual who is both a shareholder and an employee of an S corporation may attempt to avoid self-employment tax by taking only a nominal salary or no salary at all. In the latter case, the S corporation avoids its share of the payroll taxes, and the individual shareholder incurs only income tax, not Social Security or self employment tax, on the S corporation earnings. The Treasury Department’s Inspector General for Tax Administration has cautioned Congress and the IRS about this strategy, noting that almost a million S corporations with one shareholder had paid no wages or salaries. While some of those entities may have received no services from a shareholder, others may be abusing the ability to have S earnings flow to the owner without payroll taxes. The IRS has regularly challenged and defeated in court S corporation shareholders on this wage issue. As a recent report to Congress noted, establishing a fair and reasonable wage is difficult and requires the consideration of a number of factors. The courts will review the time worked by the shareholder, the salary structure in similar industries and businesses, the rate of return that the shareholder received on investment, the financial condition of the corporation, and other factors. Implications. With the Treasury Department sounding an alarm and the Taxpayer Advocate suggesting increased compliance efforts by the IRS in scrutinizing owner compensation from closely held S corporations, change may be in the wind. The IRS would rather see Congress adjust the tax law to either eliminate the exemption from self-employed Social Security tax for S corporations or, alternatively, impose a limitation on the exemption. Any legislative change is unlikely within 2008, but stay tuned when we get to 2009 with a new President and new Congress. In the meantime, for those with S corporations, give consideration to the defensibility of the compensation amount to owner-employees, and contact us if you need any assistance in evaluating the reasonableness of the position you have taken on this important issue. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
