Small Business Taxes & ManagementTM--Copyright 2008-14, A/N Group, Inc.
A question we've frequently been asked is "I'm the sole shareholder of my S corporation. Do I need to take a salary?"
The answer is a complex Yes! The instructions to the Form 1120S (U.S. Income Tax Return for an S Corporation) states "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." And the IRS takes the position that every corporation needs at least one officer to manage the business. For example, you own a small air charter service of which you are president. You don't have a pilot's license or aircraft mechanic's license so you don't do any "hands on" work. A pilot runs most of the operation such as scheduling, etc. You review the books regularly, make the final hire/fire decisions, approve bills, sign checks, etc. Even if you only work a few hours a week for the business, you should have some salary.
Why the fuss? After all, the only difference between a distribution and salary is usually the social security and medicare taxes on the salary. For example, Madison Inc. has $200,000 in profits before Fred, the only shareholder, takes a salary. If Fred takes no salary, the entire $200,000 is passed through to him as income on Schedule E. If Fred takes a salary of $110,000, he'll have salary income of $110,000 but the income passed through by Madison to him will be only $90,000 (we've ignored the effect of social security and medicare taxes as well as state and federal unemployment taxes to keep it simple). Either way he'll have $200,000 of taxable income from Madison. The IRS sees simply taking a distribution as inequitable when compared to other forms of doing business. For example, if Madison was an LLC, partnership, or sole proprietorship, the entire $200,000 would be self-employment income and subject to the self-employment tax.
In fact, there has been some talk of changing the law with respect to S corporations to make all the income passed through to the shareholders subject to the self-employment tax. The proposal may or may not make it into law. The argument for passage would be increased revenue for Social Security.
How much of a salary should you take? There's no real guidance on this. There have been only a few court cases and the circumstances have been extreme. That is, the taxpayers were taking little or no salary while generating substantial income. While we can't tell you exactly what the IRS is thinking on this point, here are some general guidelines.
Take a salary. In order to be selected by the IRS for an audit on this issue, there has to be some tip off. Leaving line 7 (Officer's Compensation) on Form 1120S blank is sure to be one factor. In addition, businesses with total receipts (plus certain other items) of more than $500,000 must file Form 1125-E, Compensation of Officers, providing compensation, percent of time devoted to the business and percent of stock owned. That provides even more detail to the IRS on compensation.
Make the salary reasonable. We know of one surgeon who took a $15,000 salary in the same year the corporation netted (after his salary) some $250,000. The surgeon was the sole income generating factor in the office. The IRS adjusted his salary to the FICA limit for that year. Clearly, the more essential you are to the business, the more important it is to take a substantial salary. In one case the taxpayer worked 12-hour days with few days off and generated most of the gross receipts for the business and managed all aspects of the business. The net income of the business was some $230,000. The taxpayer took no salary, even though he had a contract specifying $24,000 per year with incentives (which were not met). A witness testified reasonable compensation was $100,000. The court consulted the California Occupational Employment Statistics Survey for the year and another study. The court determined a reasonable salary of $83,000.
Distributions will affect your argument. In the case above the taxpayer took $240,000 in distributions. In another case the business had a loss, but the IRS and court required the taxpayer to take a salary because he took distributions. The taxpayer claimed the amounts were really repayment of loans, but was not able to prove the amounts contributed to the company constituted bona fide debt.
If you take no (or nominal) distributions you might have a strong argument that the earnings had to be retained by the business for repayment of debt, growth, purchase of equipment, loan covenants, the business is volatile and had losses in prior years, volatility of earnings, etc. If you invested large amounts of equity capital, you should be allowed to earn an adequate return on your investment. There may be other situations where you could argue against a substantial salary. Talk to your tax adviser.
If your business involvement is minimal, you may be able to get away with a small salary. You may increase your risk of an audit on the point, but there's a good chance you'll be able to convince the Service a larger salary is not appropriate.
Accumulated losses from prior years may present an argument for a low salary. However, substantial distributions in prior or the current year would blunt that argument. Taking substantial distributions at the same time you're taking no or a low salary will weigh against you. And showing a $200,000 distribution from the S corporation while taking a $20,000 salary will quickly stand out.
You'll probably be on firmer ground if you have a board of directors with some outsiders and officers' salaries (at least for shareholders) are set by the board at the beginning of the year. You'll also be better off (for a number of tax and nontax reasons) if you formalize distributions, e.g., declaring them with board approval on a regular schedule. Along the same lines, avoid paying personal expenses with corporate funds.
Here are the factors the Tax Court looked at in one case:
Some of these factors were discussed above. Others are pretty self evident. In the case of salary policy as to all employees, this factor would weigh against you if you paid high salaries to other employees, particularly other officers who were not shareholders, and no or low salaries to officer/shareholders.
The issue becomes even more complex if there is more than one officer/shareholder. There is no guarantee that if say, two equal shareholders took equal salaries, that the IRS would increase the salaries by the same percentage. In the case of a family business, if one or more shareholders renders services for the corporation or furnishes capital to the corporation without receiving reasonable compensation therefor, the IRS can make such adjustments in the items taken into account by such individual and such shareholders as may be necessary in order to reflect the value of such services or capital. That could serious affect your tax planning.
Claiming your involvement with the corporation is minimal could backfire if the corporation has losses. The IRS could argue you weren't materially participating in the business and allow the losses only against profits.
In 2008 the IRS issued Fact Sheet 2008-25 discussing this issue. Some of the material in the Fact Sheet was discussed above. Below is information from the Fact Sheet.
The Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." (That means if you're taking distributions, they can be recharacterized as salary.) In fact, that's what happened in several cases.
The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go to the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case. Some factors considered by the courts in determining reasonable compensation:
Some of these issues are the same as those listed above.
There can be other issues involved. Consider discussing salary with your tax adviser at least once a year. If he's looking out for your best interests it's probably on his list of things to review and discuss with you anyway.
Copyright 2008-2014 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. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 12/02/14