Jun 12, 2023
In a previous blog, we discussed Reasonable Compensation Analysis Reports and briefly touched on what reasonable compensation is. With the IRS increasing its manpower, the agency will be flexing its muscle once more in ways that haven’t been seen in the last three years, including more scrutiny of tax returns and how corporations are spending their dollars. Understanding what reasonable compensation is and how it will help an S-Corporation officer decrease their audit risk will be a major benefit moving forward. So, let’s delve into the topic of reasonable compensation!
An S-Corporation shareholder-employee, more commonly known as an officer, must receive reasonable compensation for the services contributed to the company through their time and efforts. This compensation must be provided before any non-wage distributions are to be considered. The IRS defines Reasonable Compensation in Internal Revenue Code § 1.162-7(b)(3) as “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” It makes sense, but how does one reach that dollar amount?
When determining Reasonable Compensation, there are three primary considerations that factor in determining what the shareholder-employee did for the S-Corporation:
If the gross receipts of the S-Corporation are generated by services of non-shareholder employees and capital and equipment, payments to the shareholder would be treated as non-wage distributions, which aren’t subject to employment taxes. However, if the gross receipts of the S-Corporation are contributable to the shareholder’s personal services, then payments to the shareholder-employee should be classified as W-2 wages.
Aside from reviewing the business’s sources of gross income received, other factors in determining reasonable compensation include:
A shareholder-employee can receive various forms of “payment,” but not all forms of compensation are subject to employment tax. When it comes to a business determining pay for a shareholder-employee, the employee should receive W-2 wages subject to employment taxes for the administrative tasks mentioned above. This means any assistance or oversight the employee provided directly to contributing to the production of gross receipts should equate to W-2 pay issued to the shareholder-employee. Additionally, if the business has a group health insurance policy and covers the premium for the employee, this will be subject to income tax on the officer’s personal income tax return.
Non-Wage Distributions can be issued in a few different forms, the most prominent being the flow-through of any profits the business realized for a tax year. They can also be received for a payment to an officer voted on by the Board of Directors. Or, and this is a big one, if the officer does not perform any services, or very minor services and is not entitled to wages, they are not considered an employee and can receive a distribution.
If we are being straightforward here, the reason is to prevent tax evasion. Historically, officers tried disguising their income received in exchange for time, efforts, and tasks performed as a “distribution”. As we have constantly made you aware, having a tax debt is not an enjoyable experience. Add in consideration for penalties and interest that would be tacked on to any incorrectly reported income and even the potential threat of legal repercussions in tax court, and one can easily determine that it is just not worth the hassle.
The process of determining reasonable compensation is a tough one! Making an error with wage versus non-wage payment to a shareholder-employee can have some serious backlash on the business and the individual involved. Have no fear, however, as the team at Golden Lion Tax Solutions can help! We have secured access to a database that will allow us to create a true Reasonable Compensation Analysis Report based on the tasks and duties performed by each officer that can not only serve as an insurance policy should a question be raised in the future, but it can also provide some wonderful market comparisons to how others are being paid in the same industries for comparable duties.
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