The first quarter of 2018 is an excellent time for owners of S corporations to consider an early-in-the-year restructuring of their compensation for tax purposes.
Tax planning should come before income is earned or expenses paid. S corporation owners and shareholders (let’s call them employee-shareholders) receive compensation in two principal ways: salary and distributions. Low-interest notes and stock options are among other methods, but compensation is primarily paid in money. An S corporation isn’t subject to corporate taxes: taxes are paid based on individual employee- shareholders’ personal tax returns. Therefore, employee-shareholders make annual, not quarterly, tax payments.
Apart from regular tax rates applied to salary, S corporation distribution compensation is considered flow-through, or pass-through, income. Depending on the facts (everything in the compensation universe is subject to a series of IRS rules) this flow-through compensation is generally taxed less than salary. Shareholders other than employees working in the business also avoid self-employment tax.
It’s a good idea for owners to report to the IRS their S corporation employee-shareholder salary and distribution schedule on their first quarter payroll tax return, which is filed in April. The early decision imperative stems from the fact that once it’s reported and paid, it’s locked in and can’t be changed later in the year.
It’s possible someone’s eyes are widening as they think they’ll arrange to be paid a smaller-than-justified salary and direct most of their income to distributions. But the IRS, anticipating such widened eyes – and questionable compensation configurations - has a “reasonable compensation” requirement. For example, to avoid a higher tax rate the owner of an S corporation can’t assign himself or herself a pittance of a salary and divert the overwhelming bulk of compensation to distributions.
A compensation restructuring for tax purposes has more than one implication. It sets for the year the amount owners and shareholders will receive. But, having made that determination, if the IRS believes the S corporation’s compensation formula to be unreasonable, it can challenge the determination.
Reasonable compensation is defined by the IRS is “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” For example, if a corporate employee-shareholder in a similar role would normally be paid in the $150,000 to $200,000 range, but instead takes only $60,000 in salary and the rest in distributions, the IRS might well zero in on such fanciful accounting and pay a call on the individuals involved.
Factors the IRS uses to determine S corporation reasonable compensation are:
- Training and experience
- Duties and responsibilities
- 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
There are a number of cases in which IRS decisions challenging the amounts S corporations have claimed as reasonable compensation. The IRS wins some and loses some, so it’s not a sure thing that an IRS challenge will result in a compensation claim being disallowed and more taxes due. The IRS doesn’t – and shouldn’t – dictate specifically what employee-shareholders should be paid and how it should be disbursed. But it does have authority in this area to determine “reasonableness.” Added to that is the new tax bill with its implications.
This means that while the first quarter is an excellent time for S corporations to make compensation decisions, it should be done with the advice and counsel of financial advisors and accounting professionals who help them decision makers find financial benefit and avoid IRS pain.
The original article was published in the Knoxville News Sentinel. For more posts by Jimmy Rodefer, please visit the Rodefer Moss Blog.