What is the issue?
The profit an S Corporation generates is not taxed at the corporate level. The profit is taxed at the individual level, as salary (w-2) for the shareholder employee or S Corporation income on the individual tax return. To the extent, the profit from the S Corporation generates before shareholder salary is classified as salary, the amount is subject to social security and Medicare taxes, both the employee share and employer share, as well as income taxes. In 2018 the first $127,400 of salary is subject to social security and Medicare tax at 15.3%. It also is subject to income tax at the federal level to a maximum of 37%. Therefore, the salary can be subject to federal taxed at 52.3 %. To the extent, the profit can be reported as S Corporation income it will be subject to the federal income tax, to a maximum of 37%. This is the reason the IRS is concerned about reasonable salary for shareholders who perform services for the corporation.
What is the IRS looking for?
The IRS is on the lookout for S Corporations that fail to pay reasonable salaries to shareholders who perform services for the corporation. The failure to pay adequate salary- or no salary at all – to the shareholder-employee is a “Red Flag” for audit by the IRS. It’s important for an S Corporation to properly compensate working shareholders to avoid a big employment tax bill in the future along with interest and penalty.
The key to establishing a reasonable salary is determining what the shareholder does for the S Corporation. Initially, we need to understand the source of the S corporation’s gross receipts.
The three major sources of gross receipts are:
- Services by the shareholder
- Services by non-shareholder employees
- Receipts primarily dependent on capital and equipment
If most of the gross receipts and profits are due to the share-holder’s personal services, the expectation by the IRS that most of the profits should be allocated as salary. On the other hand, if more of the gross receipts and profits are due to non-shareholder employees or from capital or equipment it is reasonable that the shareholder would receive distributions along with salary.
In addition, the shareholder-employee should be compensated for administrative work performed, such as assisting other employees or assets that produce receipts and profits. Some of factors the IRS utilizes to determine reasonable salary include:
- Training and experience
- Duties and Responsibility
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services?
- Compensation agreements
- The use of a formula to determine compensation
A significant point is that no IRS rule (safe Harbor) exists that insulates the s corporation from an audit on the issue. A reasonable salary depends on all the facts and circumstances in each individual case.
The 60-40 Approach:
Many CPA’s advice their clients to use what is called the “60-40 rule”. This is not an IRS rule and not a safe harbor rule. It was developed by practitioners as a simple guide for determining a reasonable salary. Under the 60- 40 approach, the profits of the S corporation before shareholders salaries would be split as 60% for salaries and 40% for distributions. The 60- 40 method is not a defense if the IRS comes calling, but it is something, and generally considered safe under normal circumstances. Let’s remember, if the S corporation is a personal service corporation, and most of the receipts and profits are generated by the individual shareholders, with one employee, the 60-40 method is not likely to satisfy the IRS. A strong case could be made in this circumstance most if not all the profits could be considered salary. At the other extreme, if the S Corporation is a construction company with large amounts of capital equipment and many non-shareholder’s employees, a case could be made that a reasonable salary could be 20% or less.
Some CPA’s advocate the 1/3, 1/3, 1/3 approach:
- 1/3 Paid as a shareholder salary
- 1/3 Distributed as return on investment
- 1/3 Retained for company growth
Under this approach, if you do not retain 1/3 in the business, you would generally allocate it 50% salary, 50% distribution. Again, this approach can be a good starting point. All the above discussed factors must be taken into consideration to justify the amount allocated to salary.
While using comparable salary information for similar businesses is a good plan to start, it becomes more applicable and reasonable as the income of the S corporation exceeds $500,000 annually.
Unfortunately, there is no way to guarantee that the salaries set for the shareholder employee will pass muster with the IRS. If you do your homework, have a reasonable basis for decision and show you made a good faith effort to pay reasonable shareholders salaries, the IRS is more likely to defer to your judgment.