Reasonable Compensation

for S Corporation Owners

This article discusses the S Corporation entity:. 
Click on the link for a brief overview of the differences between the  C Corporation,  S Corporation or  LLC

Officers are employees, therefore they must be compensated as employees receiving paychecks- read more - IRS article

November 2005 The IRS announced that the number of tax-return audits in 2005 increased by over 20 percent, to 1.22 million, the highest number in seven years. IRS Commissioner Mark W. Everson said   "Part of the increases comes from improved procedures and part from a new emphasis on enforcement," he said. The IRS budget increased 4.3 percent for 2006  with a nearly 8 percent increase for enforcement.  The Wasington post published this about the 2007 budget "The IRS, after years of shifting resources to improve taxpayer service, has come under fire for what critics see as inadequate attention to enforcement. So the agency has been swinging back in recent years, and that trend would continue next year as budget authority for taxpayer assistance, return processing and other management functions would decline 1.2 percent, while enforcement would rise by 1.8 percent"

The years (15 or more) where we  have seen a "kindler & gentler" IRS with very few audits is coming to an end. Congress is sending a message to the IRS.  Collect More! So be wary S Corporation owners.   The issue of reasonable compensation is an easy IRS  target and a large revenue generator for the IRS.  Consider contacting a local employment agency, provide them with a list of your management responsibilities and hours worked and have them put into writing what it would cost to hire a person to fill your shoes and keep this paper in the same file where you keep a copy of your tax returns.

S Corp owners may withdraw earnings from the business as:

• distributions  from S corporation earnings (similar to dividends of a C corporation)
• wages
• repayment of loans 
• reimbursed expenses

Distributions from an S Corp are not subject to FICA and Medicare taxes.  This translates to a  potential savings of up to 15.3%.   Withdrawals in the form of distributions (dividends) are still subject to federal taxes at the ordinary income tax rates-  top tax bracket 35% (Recently tax changes provide for a tax break on C corporations dividends -top rate of  15% - but this does not apply to S corporation distributions.)

Wages are subject to FICA and Medicare payroll taxes (15.3%) and are subject to ordinary income tax rates. But the bonus to paying wages opens up the opportunity to fund a pension that will save federal taxes at the ordinary income rates (top tax rate 35%).  Pension rules generally permit funding a pension as a percentage of your wage ( Distributions are not wages and therefore are not counted in the pension contribution calculation). The tax savings will continue when money is contributed to a pension because the pension will grow tax free until retirement (compounding the growth of the investment).  
  
Loans should be repaid with reasonable interest which is subject to income tax but (interest) is deductible as a business expense.  So, as an average taxpayer you will have not have an increase in taxes as a result of the interest paid, but this is a bit of bureaucracy which we recommend you follow.  Paying interest will provide support that the loan is arms length and not a disguised capital contribution.  Good business practice dictates that when you lend money to your corporation you must get a formal Note (in writing). If you want the loan repaid without tax consequence, you will follow these guidelines.  Most business owners will fund the start-up checking account with money from their personal accounts.  A portion of these funds should be allocated on the balance sheet as a capital contribution (payment for the purchase of company stock). The amount allocated to Capital should be a reasonable value ( for example  $1000 for  a service business, more for a business that requires significant purchases of inventory or machinery). The remainder invested may be repaid as a loan provided there is a note drawn and interest payments are made at regular intervals at a reasonable rate of interest according to the note document.   Lack of interest payments would infer the debt is contingent upon corporate profits, which is considered a second class of stock. A second class of stock will permit the IRS to discard the S election and submit your company to C corporation taxes (double taxation.)

Expenses paid from an owners pocket can be repaid to the S Corp owner with a company check. Just a side note - try to pay the vendor/ payee directly with company funds. There could be more scrutiny with reimbursed expenses than payments directly from the business account .  For charge cards used for both personal and business purposes, send 2 checks, one from your personal account to pay personal charges and one from the business account to pay business expenses

Wages and Distributions compared

Strategy 1: Lets take the example of a new attorney who for the first year of business will earn after expenses
(but before wages)   $90,000 (the 2005 FICA limit). For every dollar his wage falls below the social security limit he and his company saves a combined 15.3 cents in payroll taxes.  Lets assume that from these S Corporation earnings of $90,000 a wage of $50,000 per year is paid and the remainder of  $40,000 is paid as a  "distribution".  The payroll tax savings ( $40,000 -not subject to social security-   x 15.3% ) would save $6,120 per year.  

The attorney starts a profit sharing pension plan in year one and contributes the maximum (25% of wages with an upper limit of $42,000 for 2005).  With a $50,000 wage his pension contribution is limited to $12,500 ($50,000 x 25%). This pension expense will save as much as $2500  (depending upon his personal tax bracket) in federal income taxes.

With an allocation of $50,000 wage and $40,000 distributions and $12,500 pension contribution he has saved  $8,620 in federal income taxes.

Strategy 2: All earnings paid as wages

$90,000 paid as wages. While there is no social security tax savings, the attorney can contribute $22,500  (25% x 87,000) as a pension contribution saving as much as (depending on his tax bracket)  $4,700 on federal income taxes .

 Result of selecting Strategy 1 over Strategy 2:  An increased tax savings of $3,400.

Benefits of strategy 2:

• The additional pension contribution ($10,000) will grow "tax free" until retirement, preserving wealth and compounding earnings.
• Contributions are made toward  social security benefits. 
  ( "distributions" - s corp dividends - are not taxed on  Fica/Medicare therefore not counted towards your retirement benefit. To find out how withdrawing earnings on distributions rather than as  of wages  request a free social security statement.  Request several statements. Complete each request with a different projected wage.  For a quick calculation can use the online calculators and input various scenarios to see how your benefits can be affected by your decisions.

        Other - in most cases if you contribute 25% to your pension, you will be required to contribute 25% to your employee's pension.

It is important to consult with your CPA to determine the right balance between wage and "distributions" and to  revisit this decision annually. 

Stick to the program!

Once you have established the most tax effective strategy, follow it.  Click on this link:  The IRS loves to collect payroll taxes and will seek out an S Corporation that pays NO wages to officers of the corporation or pays unreasonably small wages.  Why?  To collect additional payroll taxes.

Here is an option that will provide for flexible cash payments but still adhere to a structured wage payment.
Pay yourself a wage once a month (or more as long as the intervals are regular and the amount is consistent) on the first of every month and on the 15th pay yourself a "distribution" from S Corp earnings (cash permitting).

Monthly "distributions" can vary in amounts or not be paid at all. 
Wages should be paid at regular intervals in regular amounts.

Try not to give the IRS ammunition for reclassifying distributions to wages.  The result is a  catastrophe.  Payroll taxes plus late payment and filing penalties. Avoid problems by complying with these suggestions:

• Distributions should  recorded in the corporate minutes each time a dividend payment is made.
• The distribution payment should be stated as a dollar value per share (to the nearest whole dollar)  times the number of shares held.
• Do not make "distributions" more frequently than once a month.  If cash flow does not permit a dividend one month, wait until the 15th (or declaration date) of the following month for a distribution payment. 
• Distributions must be paid to all shareholders on the same date in proportion to the ownership percentage. Non pro rata distributions could result in the loss of S status because of the one class of stock requirement.
• Do not pay your personal bills through the business and call them distributions.
• Pay reasonable wages (see below for a discussion of reasonable)
• If your company is losing money and you do not have retained earnings from prior years, do not pay distributions. In other words, do not borrow money (higher vendor payables, or company borrows from bank, or company increases credit card debt) and then pay yourself a distribution. This creates "basis" problems and red flags your tax return for scrutiny by the IRS

The last consideration, and most important, is whether your split between wage and distributions seems reasonable to the IRS.  Below are a few guidelines of how the IRS determines reasonableness.

Compensation is deductible only to the extent it is reasonable. Compensation paid to employee-shareholders  must be paid purely for services, or have a purely compensatory purpose, in order to be deductible

Closely held corporations that have the controlling shareholders and their families setting their own compensation figures will be more closely scrutinized under an audit. 

Other factors determining reasonableness include:  These are important and your position should be defined before determining your gross wage.

• the employee's qualifications and role in the company, including factors such as hours worked  the employee's position, duties performed, and his overall contributions to the company
• the character and condition of the company, including factors such as the size of the company, the complexity of its business and the general economic conditions
• a comparison of the employee's compensation with the compensation paid by similar companies for comparable services
• ability and achievements of the employee (would an outside investor have paid the compensation amount based on performance);
• volume of business handled by the employee;
• complexities of the business;
• relationship of compensation to gross and net income of the business;
• living conditions in locality;
• the salary policy of the company for all its employees and the particular employee's salary history with the company

These factors are not listed in any order of importance. No one factor will determine a  particular case. However, in a particular situation, a single factor could be persuasive.

Paying distributions as opposed to  wages vs distributions will save tax dollars.  Even if you pay a wage of over the Social security limit  of  $90,000 (for 2005)  there is still a 2.9% savings  (the Medicare rate) on the portion of earnings taken as distributions (not wages).  For new businesses, you may set a lower reasonable wage if most hours are spent on tasks that are administrative (a lower paying rate) or established business owners might have employees that are capable of managing the business and requiring less time on the job for the owner translating into a lower reasonable compensation rate.

It is very important to work with your CPA when setting  reasonable compensation. Keep a record in the corporate minutes on what facts and circumstances were used when calculating a value for reasonable. The issue of reasonable compensation is a difficult one, discuss this issue at the start of each year.   

Set up the following accounts to help track the payments:  From the List menu, select accounts and add new account (control + N)

Long term liability accounts: 
Officer Loan- Joe
Officer Loan-Rich

Equity Accounts
Capital Contributions -Joe
Capital Contributions -Rich
Distributions -Joe
Distributions - Rich   

Expense account
Interest Expense
Salaries -Officers

Lets  assume 2 Shareholders - Joe and Rich

Scenario A :  Joe  tells you to cut the check that is not business related, and does not identify what it is for

I suggest coding the entire amount to Officer Loan payments. 

Distributions must be paid in equal amounts based on ownership percentage to all shareholders on the same date. So if Joe takes a  check, so must Rich. And if this does not occur, don't call it a distribution.  It does not matter that the officer loan account is a liability account code the loan receivable  payment to officer loan -Joe.  At the end of the year, the accountant will create any journal entries needed to reclassify appropriate amounts to salary and capital. Ask Joe to make a deposit of  $500 to $1000 of his own funds into the business checking to be categorized to Officer Loan payments.  This 'cushion'  will give you CPA the support needed to call the deposit interest from officer (if necessary) at the end of the year.

Print out a quarterly report of account Officer loan -Joe and faxing to the CPA with a message as follows:  "Please let me know if you believe any of these amounts should be categorized as salary and help me make the proper adjustment in QuickBooks. Also  provide assistance in making sure any amounts reclassified as wages have been grossed up in my payroll summary report with adequate tax withholdings so that I can pay the payroll taxes timely".

Scenario B:  To start up the new business, Rich deposits 10,000 of his own funds into the account and Joe deposits nothing. I suggest:

Classify part of the $10,000 to Joe's capital account  based on a per share price
Classify part of the $10,000  to Rich's capital account based on the same per share price
Classify the remainder of the $10,000 to Rich's officer loan account

Capital stock must be purchased for a reasonable amount. S Corporations only have one class of stock so the price must be the same per share for each owner. Therefore, for Joe to be an owner, he must pay the same price per share as Rich. Discuss the possibility of  Rich lending money to Joe for the purchase (a transaction which is a personal transaction - has nothing to do with the business).  Decide on a price per share, code part of the 10,000 to each capital account and classify the excess as a loan payable to officer loan - Rich. If Rich is not in agreement with this, then Joe needs to have amounts withheld from his paycheck to pay for the stock. 

Continuation of Scenario B :  Rich now has loan principle due to him from the corporation
For a loan to be considered valid by the IRS, interest must be paid to Rich in regular installments. Quarterly would be a good choice.  The interest rate should approximate fair market value interest rates. Write a check quarterly to Rich and code to Interest expense.

At the end of the year, a 1099-INT must be completed and mailed to Rich before 2/28/xx. One copy is mailed to the IRS with form 1098 and one copy send into the State.

Scenario C:  Paychecks are cut to Joe and Rich for wages without having any taxes withheld. 

Gross up the net checks to gross officer salaries and remit payroll taxes as due

Scenario D:  Its time to pay the American Express bill and Joe never provides you with the statement.

Sit down with the Joe for a heart to heart.  Suggest that he give you the credit card statement so you can pull out every single transaction that could possibly be construed as business expense and categorize accordingly.   The remainder classify to "officer loan-Joe" and let the accountant  determine the best course of action.  Saving the categorizing to the end of the year means lost statements plus higher tax preparation fees.  Don't forget to give the accountant a listing of the transactions in the officer loan account before the year end. And ask Joe to deposit $500 or $1000 into the business account so the accountant has some flexibility in coding some amount as interest paid from Joe to the company on any officer loan that exists.  The goal is to make sure that the IRS will not come back and construe the payment as a distribution from earnings to Joe. A distribution that would create an inequity between Joe & Rich's ownership %.  Remember, making inequitable payments  creates the basis for the IRS to assign a second class of stock and jeopardizes the S Corp Election.  Lose an S Election and be prepared to pay hefty penalties and late income taxes on the corporation.

Read about automatic download of  American Express transactions into QuickBooks. It might be a good idea to acquire a separate AmEX account that the owners use strictly or business purposes where the bookkeeper can download new transactions daily and categorize accordingly. And questions can be answered while the purchase is still fresh in the owner's mind.

Scenario E:  Rich gets sick while on vacation and receives medical care from a physician who is out of network.  He asks you to pay the bill. 

Code the payment to "officer loan-Rich" and remind Rich that health costs are a personal expense and are not deductible for the S Corporation. In fact if the benefit is not offered to all employees, it must be grossed up in wages and included on the W-2.  Pay the bill and ask Rich to reimburse the company or include the payment in wages.  Read more about reporting  S Corporation owners health benefits in the W-2 at year end.  

Scenario F:   Its April 15th and both Rich and Joe have huge tax bills on their personal 1040's. They ask you to cut a check in the amount of each tax liability payable to the IRS.  The amount to be paid on behalf of each owner is not in proportion to their ownership percentage:

If possible, cut a check to each owner in an amount that is proportionate to ownership and code both checks to capital distributions- Joe and distributions Rich  . Let them deposit into their personal accounts and write their own checks.  Don't give the IRS any support for a "second class of stock argument"

If not possible, cut the tax checks,  plus an additional check in the amount of the difference between the first two tax checks and pay it  to the shareholder who had the lesser tax bill. (This assumes equal ownership, if this not the case, calculate the amount needed to have distributions in line with ownership and payout the shortage)  Code all three checks to the owner's distribution accounts..

Scenario G:  The company is making lots of money, but the extra cash is kept within the company to fund growing inventory and accounts receivable.  Distributions are less than earnings. 

Do nothing. Its okay to payout less than the earnings.  The owners will still be taxed on the income but when payment is finally made,  it is does not get taxed again.  (Some states have a tax on assets retained in the company as of 12/31, for these companies, check with your accountant and if cash is subject to this tax, payout available cash by 12/31.  Have the owners deposit the payout into their personal accounts and if the company is now short on funds, the owners can write a check to the company from their personal accounts in early January to loan the company the money needed.  Don't forget to pay the owners interest on the loans quarterly until the loan is repaid.

Do not track what money has been taxed and what has not.  That is the purpose of the accumulated adjustments account on the tax return (earnings previously reported on the owners 1040 tax return). You accountant based on your regular bookkeeping entries will be able to determine what the balance remaining is in the accumulated adjustments account.

Scenario H:   The company is loosing money and cannot afford to pay payroll taxes on the money withdrawn by the owners. 

Get the accountant involved.  If the company is loosing money and there are no retained earnings from prior years, withdrawals by the owners are deemed salaries and are subject to payroll taxes.  Loans receivable from owners of over $10,000 are subject to scrutiny by the IRS.  Don't red flag the tax return with these officer loans receivable.  Have the accountant discuss other sources of cash to help defer household expenses until the cash flow loosens up.
 

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