S-Corp and Reasonable Comp and the IRS…. Oh My!
You’re not in Kansas anymore Dorothy! Just like lions, tigers and bears, S Corporations, Reasonable Compensation and the IRS are very much real. Individually, each one can be scary. Together, they can be a nightmare. Before you continue down the yellow brick road of S-Corps and entrepreneurship, you should visit the Wizard. She can explain it all! We’re off to see the Wizard…
What is an S-Corp?
An S-Corp or Subchapter S Corporation is a closely held corporation, similar to a regular Corporation. S-Corps enjoy the advantages of incorporation, however, the entity has elected to be taxed as if it were a partnership and not a corporation under Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361-1379). All corporate income, losses, deductions and credits flow thru the entity to the shareholder level. Unlike a Corporation, the S-Corp itself is not taxed. There is no “double tax” feature to an S-Corp.
According to the IRS, to qualify for a small business corporation or S-Corp, your corporation must meet the following 5 requirements:
- Be a domestic corporation,
- Have only individuals, certain trusts and estates as shareholders,
- Have no more than 100 shareholders,
- Have only one class of stock,
- Not be an ineligible corporation.
Reasonable Compensation (Reasonable Comp)
One of the most overlooked requirements to the S-Corp business structure is the concept of reasonable compensation. According to the IRS, S Corporations must pay a reasonable compensation to a shareholder-employee in return for services that the employee provided to the corporation before any non-wage distributions may be made to the shareholder-employee. Oh My!!
Reasonable Comp should not be viewed as your value as a business owner or indicative of your self-worth. Reasonable Comp, however, should be viewed as replacement cost. What would it cost your corporation to pay someone else to provide all the services you currently provide to your business? Think about it… you are a lawyer with 10 years’ experience. You have your own practice and you have elected to be classified as an S-Corp. You generated revenue as well as handle all the administrative aspects of the of the practice. You picked a strong, round number and decided to pay yourself only $24K per year. Now, is it reasonable that an outside lawyer, with the same experience, performing all the same services for your firm, would accept a salary of only $24K? Probably not….
The IRS is paying closer attention to wages paid and distributions made to shareholder-employees of S-Corporations. Why? Often times, shareholder-employees pay themselves minimal salaries to avoid payroll taxes, etc. Then, the shareholder-employee has large distributions from the corporation that are not subject to payroll taxes. For example, owner pays himself $25K as salary & has distributions that total $75K. The IRS has the right to reclassify previous non-wage distributions to wages, causing penalties & fines for nonpayment of taxes, under reporting income, etc. Reasonable Comp must be paid before distributions can be made. Oh My!!
As a shareholder-employee, your salary or Reasonable Comp should be researched and documented. In other words, don’t just pull a salary figure out of the sky because it looks good on paper or yields the lower tax liability. This method will not stand in an IRS audit or examination. Perform the due diligence of determining the Reasonable Comp for your services based on industry, experience, and duties performed. Document how you derived the Reasonable Comp figure. I would even suggest going the extra step of recording the salary in the minutes of the Board meeting.
It is never too late to review the concept of Reasonable Comp. It doesn’t matter if your S-Corp is already established or you are in the planning stages. I am here to serve in the Wizard capacity to help ensure you & your firm are in compliance regarding Reasonable Comp for your S-Corp.
The information presented is based off generalizations. Please consult a trusted CPA to determine the appropriate steps for your particular business and tax situation.
Hope your business blings in the year 2016!