Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
Wages paid to officer/shareholders of S corporations are subject employment (and unemployment) taxes and withholding for federal purposes and withholding, unemployment, etc. for state purposes. Distributions from the corporation aren't subject to these taxes. That's the big difference, and the IRS is aware that more than a few S corporation employee/shareholders are taken little or no salary to avoid the taxes. We've discussed the importance of taking a salary in earlier articles, but two recent cases have shown the aggressive as well as the surprising positions of the IRS.
Salary or distribution? Does it make a difference? Generally, only with respect to employment and any other taxes related to wages. Why? Since the income (or losses) of an S corporation are passed through to the shareholders and reported on their individual tax returns, as is any salary, and both are taxed at the same rate, it doesn't make a difference. For example, Fred is the sole shareholder of Madison Inc. It's December 31 and Fred hasn't paid himself a salary for the year. Madison is showing $100,000 of income. If Fred receives no salary, the $100,000 of income will be passed through and shown on Schedule E of his Form 1040. If Fred takes a $70,000 salary, that amount will be reported on his Form 1040 as salary; the net income of Madison will be $30,000 (before taking into account employment taxes, $100,000 less $70,000 salary) and reported on Schedule E. Either way, Fred will report $100,000 on his Form 1040. (We ignored employment taxes to simplify the numbers.)There are some situations where taking a salary vs. a distribution makes a difference. For example, Fred has no basis in Madison Inc. and the company has just broken even by December 31. Fred takes a $50,000 salary creating a $50,000 loss. Fred has $50,000 income from the salary but can't take the $50,000 loss because he has no basis for which to do so. Another situation that can create a problem is where there are two or more shareholders; where there are two or more shareholders and one or more of them does not materially participate in the business, etc. That's beyond the scope of this article.
For employment tax purposes, wages are defined as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash", with some special exceptions. Notwithstanding the manner in which an employer characterizes payments made to an employee, the critical fact is whether a payment is actually received as remuneration for employment. An officer who performs more than minor services for a corporation and who receives remuneration in any form for those services is considered an employee, and his or her wages are subject to the employer's payment of Federal employment taxes.
If an employee/shareholder took only distributions, the government wouldn't collect employment taxes. In the case of an LLC, partnership, and sole proprietorship, all the earnings of the owners are subject to the self-employment tax, with certain exceptions.
While the issue rarely came up in the Tax Court 10 years ago, it's now almost common.
Two recent cases show that the IRS is serious about this issue and has taken a position that can only be described as aggressive. In the first case, Glass Blocks Unlimited (T.C. Memo. 2013-180) the officer/shareholder was the only employee of the business (there were per-diem workers) and he took no salary for the two years at issue. The business was under pressure and had net income of $877 for 2007 and $8,950 for 2008. The taxpayer transferred $30,000 to the business from a family trust and the taxpayer's fiance at the time contributed $15,000. An additional $10,000 was transferred to the business in 2008.
The taxpayer took distributions of at least $30,844 from the business in 2007 and $31,644 in 2008. The taxpayer claimed that the amounts distributed represented, at least in part, repayment of the "loans" advanced to the business. The Court reviewed all the factors that normally indicate amounts forwarded to the business are loans rather than capital contributions and found the amounts were clearly capital contributions. The IRS claimed that the full amounts the shareholder received were salary, not distributions. The Court agreed. That made the taxpayer liable for social security and medicare taxes (both the employer's as well as the employee's portions) as well as penalties.
In finding the amounts the shareholder received were salary not loan repayments or distributions, the Court examined what reasonable compensation would be for the shareholder. While the taxpayer argued the work was minimal and undemanding, the Court noted the taxpayer worked at the business full time and performed all the managerial functions as well as being responsible for generating sales.
The most significant point here is that the distributions were classified as salary despite the minimal earnings of the business. One might have concluded that if the business had no or only nominal income, a salary would not be imputed.
In the second case, Sean McAlary Ltd Inc. (T.C. Summ. Op. 2013-62), the sole shareholder was also the S corporation's president, secretary, treasurer and sole director. The firm was a real estate brokerage and the shareholder was the only person working for the firm with a broker's license. He managed all aspects of petitioner's operations, including recruiting and supervising sales agents, conducting real estate sales, procuring advertising, purchasing supplies, and maintaining basic books and records. He often worked 12-hour days with few days off. While the business employed eight sales agents during 2006, the president/shareholder generated most of the gross receipts. For 2006, the corporation reported net income of $231,454, with no wages or compensation for services claimed for the sole shareholder. The shareholder took $240,000 in distributions from the corporation during that year.
The IRS used an expert witness who analyzed the shareholder's job functions and consulted the California Occupational Employment Statistics Survey for that year. He also consulted the Risk Management Association Annual Statement Studies that provided information he applied to the taxpayer's profit margin and other ratios. The witness testified that reasonable compensation should be $100,755. The taxpayer argued he had a contract with the corporation that specified he was to receive a salary of $24,000 plus incentives based on the number of sales agents (the incentives were not met). The Court noted that the shareholder was on both sides of the table when the agreement was executed, occupying the positions of both employer and employee and the agreement was clearly not one negotiated at arm's-length.
The Court went on to say courts have weighed various factors in assessing the reasonableness of compensation, including the employee's qualifications, the nature, extent, and scope of the employee's work, the size and complexity of the business, prevailing general economic conditions, the employee's compensation as a percentage of gross and net income, the employee/shareholder's compensation compared with distributions to shareholders, the employee/shareholder's compensation compared with that paid to nonshareholder/employees, prevailing rates of compensation for comparable positions in comparable concerns, and comparable compensation paid to a particular shareholder/employee in previous years where the corporation has a limited number of officers. The Court noted the shareholder single-handedly conducted the taxpayer's daily business operations, making all management decisions while also engaging in real estate sales transactions on petitioner's behalf as both a broker and a sales agent. Even though he was relatively new to the real estate sales industry, the commissions he earned represented most of the corporation's gross receipts. The Court recognized the favorable market conditions. Nonetheless, although taxpayer's operation was modest and the number of agents that he supervised was small, he was committed to the success of the operation as evidenced by his willingness to work long hours with few days off. The taxpayer's profit margin during the year in issue slightly exceeded the average of its peers in the industry.
The Court held a reasonable salary for the year at issue should be $83,200.
What to Do
There's no easy answer here. But there are some things you can do to reduce your chances of an IRS challenge in the first place and increase your chances of winning in a dispute.
Take a salary. With electronically filed returns it's easy for the IRS to simply search for a return with nothing on line 7 (officer's compensation). Any amount is significantly better than nothing.
No profit? You may still not be able to avoid taking a salary, particularly if you take distributions from the business. Keep in mind that the Courts and IRS are saying, if you provide services to the business you must be compensated.
Distributions. While it was surprising that in the first case the court found the entire amount of the distribution to be salary, the amount was relatively low. What would have happened if there were no distributions? That question wasn't answered. But a small salary accompanied by large distributions would make it hard to argue your compensation was adequate.
Contract. The second case shows that having a contract may not help. But in this case there was only one shareholder and director. If you have more than one shareholder (and you're unrelated), a salary agreement might hold up, particularly if you can show there were economic reasons. For example, the business needs capital to expand and the contract provides that a portion of salaries are to increase significantly in the future. But distributions would contradict that argument.
Comparable salaries. There is never a truly comparable salary, but you can get close. Look at what presidents, vice presidents, etc. of similar companies are earning. Then adjust for your profitability. You may be on safer ground if you have your CPA do the work and recommend a salary. Even if you're wrong, it shows you tried. Many of the cases have involved shareholders who took a clearly inadequate salary. For example, an attorney with a very successful practice taking a $50,000 salary.
Participation in the business. If your participation in the business is limited, you should be able to take a smaller salary. Be sure you can document that. You might want to keep a log showing time spent in other businesses, your vacation home, etc. Keep in mind that failing to show you materially participate can have other consequences such as being unable to take any losses, subjecting you to the 3.8% net investment income tax, etc.
Other points. The new medicare tax on higher earners gives the IRS additional incentive to look at this issue. Worse, Congress has talked about changing the rules such that all earnings would be subject to employment taxes, just like in a sole proprietorship, partnership, etc.
Talk to your tax advisor. He or she may have other suggestions depending on your specific situation.
Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISBN 1089-1536
--Last Update 08/27/13