The Internal Revenue Service (IRS) is continuing to scrutinize S corporations for reasonable compensation of salary paid to its officers/shareholders and it is now also considering the timing of such compensation (see below).The IRS has found that in recent years, there has been tax avoidance by company officers that fail to pay themselves any, or pay themselves a nominal, salary throughout the year. Officers/shareholders have received pass-through income and distributions from an S corporation in lieu of salary in order to avoid paying payroll taxes on such income.Thus, we are advising our clients in the following areas to minimize IRS scrutiny related to shareholder/officer compensation.
The instructions to Form 1120S, U.S. Income Tax Return for an S Corporation, specifically 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.”There are no specific guidelines for reasonable compensation in the Internal Revenue Code and the Regulations provide only that “reasonable compensation is an amount paid for like service by like enterprise under like circumstances (Reg. 1.162-7(a)(3) and Reg. 1366-3(a)).”
Various courts have ruled on the issue based on their determinations on the facts and circumstances of each separate case.Some of the factors considered by the courts in determining reasonable compensation include:
1. The character and financial condition of the corporation;
2. The role the shareholder plays in the corporation, including the employee’s position, hours worked, and duties performed;
3. The corporation’s compensation policy for all employees and the shareholder’s individual salary history including the corporation’s internal consistency in establishing the shareholder’s salary;
4. How the compensation compares with similarly situated employees of similar companies;
5. Conflicts of interest in setting compensation levels;
6. Whether a hypothetical independent investor would conclude that there is adequate return on investment after considering the shareholder’s compensation;
7. The employee’s qualifications;
8. The size and complexity of the business;
9. A comparison of salaries paid to sales and net income;
10. General economic conditions;
11. Comparison of salaries to shareholder distributions and retained earnings;
12. Compensation paid in prior years;
13. The corporation’s dividend history;
14. Whether the employee and employer dealt at arms’ length;
15. Whether the employee guaranteed the employer’s debt;
16. Timing and manner of paying bonuses to key people; and
17. The use of a formula to determine compensation.
Please note that the aforementioned list of factors is not all-inclusive.Also note that there are no single factors that govern, but rather a combination of factors that must be considered for each individual corporation.Overall, case law shows that the better the documentation (as in the corporate minutes, etc.) and the greater the business reasons for the payments by the corporation, the more likely the compensation will withstand an IRS audit.
Timing of Compensation
An item that has received very recent IRS attention is the timing of shareholder/officer compensation.Compensation that is paid once a year or distributions or loans made throughout the year that are then converted to payroll at year-end are methods that are now frowned upon.The IRS may require that these amounts be treated as late reported salary payments.Thus, we are advising our clients to pay its shareholders’/officers’ a salary at regular intervals (such as monthly or quarterly) as opposed to once a year.Related payroll taxes should also be paid regularly, when cash is available to the shareholders/officers.Furthermore, any bonuses to be paid to shareholders/officers should be considered periodically throughout the year versus solely at year-end to minimize IRS scrutiny.
In conclusion, we recommend that a reasonable salary amount be determined for all shareholders/officers of an S corporation.Furthermore, the business reasons surrounding the amount of compensation should be clearly documented should the IRS warrant an audit.We also recommend that the shareholders’/officers’ salaries and related payroll taxes be paid at regular intervals with bonus considerations on a periodic basis.If you would like to discuss reasonable salary for your shareholders/officers or the timing of such payments, please feel free to contact us.