Any salary to an S corporation shareholder-employee that is below a reasonable amount is a red flag to the IRS and subject to IRS scrutiny, especially when the salary is zero. The IRS not only attempt to collect total FICA tax and FUTA tax, but it may also collect penalties from the corporation for not filing its employment tax returns (Forms 940 and 941), for late deposit of the employment taxes, and also for failure to withhold income taxes on shareholder-employee’s salary. IRS may also impose penalty upto 20% for negligence, careless, reckless, or intentional disregard of the rules and regulations. Recharacterization of distributions and loans as salaries can seriously impact cash flow of Shareholder or an S Corporation.
When S corporation officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.
Any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment for services are employees whose compensation is subject to federal employment taxes.
There is an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.
What’s a Reasonable Salary?
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, 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 Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services?
The use of a formula to determine compensation
Medical Insurance Premiums treated as wages.
The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.
A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.
We have considered the situation where an S corporation is paying reasonable compensation to its shareholder-employee. The motive and desired tax position of IRS and taxpayers might be opposite for a C Corporation. IRS always scrutinize paying more than reasonable compensation in case of a C Corporation, while paying less then reasonable compensation in case of an S Corporation.
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Source by Sue