A General Overview of S-Corporations and Shareholder Compensation
When deciding on the best entity type for your business, there are several factors to consider, especially when it comes to taxation. One popular option for small and medium-sized businesses is the S-Corporation election, which can provide significant tax savings as well as limited liability.
Limited Liability, No Double Taxation
An S-corporation is a hybrid entity that provides limited liability similar to a C-corporation, but unlike a C-corporation, an S-corporation is not subject to double taxation. In a C-corporation, business income is taxed at the corporate level when profits are earned and the shareholders are taxed again on any dividend payments received from the corporation on their individual tax return.
Passthrough Entity
An S-corporation does not pay tax at the corporate level (although state franchise and pass-through entity taxes could be applicable) but acts as a pass-through entity. Its tax items pass through to the shareholders and are taxed at the shareholders’ individual rates. The corporation files Form 1120-S, which provides a breakdown of the S-corporations income and expenses, and each shareholder receives a K-1 to report their share of the corporate income and tax attributes. These items include income, gain, loss, deductions, credits, charitable contributions and other information and are reported on the shareholders personal tax return. It's important to note that shareholders report these items on their tax return and pay tax (if there is taxable income) regardless of whether they receive cash distributions from the S-corporation in that year.
Distributions
Distributions from the S-corporation usually have no impact on the shareholders’ individual tax return and must be made proportionally to the shareholders ownership percentage in the S-corporation. The S-Corporation maintains an Accumulated Adjustment Account (AAA) on Schedule M-2 of Form 1120-S. This account is primarily increased by the taxable income of the S-corporation reported each year and is reduced by losses and shareholder distributions. This account represents the previously taxed earnings of the S-corporation. Since this income was passed through on the K-1 and taxed when it was earned, distributions to shareholders from S-corporations are not taxed until all basis is depleted and are treated as follows:
Distributions are first treated as a tax-free recovery of shareholder basis to the extent the distributions do not exceed the corporation's AAA balance.
To the extent distributions exceed the AAA, the distributions are next treated as taxable dividends to the extent of the S-corporation's earnings in profits (E&P). This only applies if the S-corporation was formerly a C-corporation. If the S-corporation was never a C-corporation, the E&P account would not exist and this tier is skipped.
S-corporation distributions in excess of the AAA and earnings and profits are treated as a tax-free recovery of basis, to the extent of the shareholder's remaining stock basis.
Once the shareholder basis is completely depleted, the distribution will be treated as a gain from the sale of stock.
Salary Requirement
In addition to avoiding double taxation, an S-corporation can offer reduced employment taxes. Unlike a partnership or sole proprietorship, the ordinary business income of the S-corporation is not subject to self-employment tax for owners that are working in the business.
A shareholder of a profitable S-corporation could be tempted to pay himself or herself no salary at all and take only distributions of the previously taxed earnings from AAA. This would eliminate any Self Employment tax that would have been paid if the entity were a partnership or sole proprietorship and would avoid any payroll tax on the salary the shareholder would have paid himself or herself if wages were paid. The IRS has challenged these attempts to avoid employment tax, and the courts have consistently ruled in favor of the IRS in cases where businesses have tried to avoid paying employment taxes by compensating owners primarily through distributions.
As a result, S-corporations are required to pay reasonable compensation to a shareholder-employee in return for the services that the employee provides to the corporation. Failure to pay a reasonable salary will draw IRS scrutiny leading to IRS audits. The IRS has the authority to recharacterize distributions as wages leading to additional employment tax due, as well the associated penalties and interest.
The challenge is that reasonable compensation is subjective. It’s important to carefully choose a salary amount that will not draw scrutiny while still maintaining the benefit of the S-Corporation election.
How to determine a Salary
When attempting to decide on an appropriate amount to pay in salary to an S-corporation shareholder, there are several factors to consider:
Services provided by the shareholder
Services of non-shareholder employees
Capital and equipment
To the extent that gross revenues are generated by non-shareholder employees, or capital equipment, payments to the shareholder should not be considered self-employment income. Gross revenues produced by the performance of personal services of the shareholder should be considered subject to employment taxes and reportable as wages.
In addition to examining gross revenues, the shareholder should also consider additional factors when determining a salary that relate to the administrative functions of the shareholder in generating gross revenues from non-shareholder employees and capital equipment. These factors include:
Training and experience - Expertise and qualifications play a role in determining what a reasonable salary should be. Shareholders with specialized training or many years of experience in their industry should earn higher salaries.
Duties and responsibilities - Shareholders who manage significant aspects of the business, oversee operations, or hold critical decision-making roles should generally have higher compensation than those with limited responsibilities.
Time and effort devoted to the business - A full-time commitment should command a higher salary than if the shareholder only works part-time or in a passive role.
Dividend history - Distributions made to shareholders can also influence salary considerations. If a significant portion of income is paid out as dividends, the salary portion may be lower, However, the IRS will scrutinize this stating that a reasonable salary must be paid before distributions.
Payments to non-shareholder employees - If other employees are being paid appropriately for their services, the shareholder should not drastically underpay themselves for similar or greater responsibilities.
Timing and manner of paying bonuses to key people - The shareholder should consider the structure of compensation packages within the business, including bonuses to key employees. Are bonuses performance-based, seasonal, or discretionary?
Age of the business - A newer less established business can justify paying a lower salary than a successful, established business.
What comparable businesses pay for similar services - Comparing the shareholder’s salary with industry standards by looking at similar businesses in the same field and geographic region can help determine what is considered reasonable compensation.
Compensation agreements - Written agreements that outline salary, bonuses, and other compensation can help establish the reasonableness of the pay structure. However, these agreements should align with the actual duties performed by the shareholder.
The use of a formula to determine compensation - Some businesses use formulas to determine compensation, such as basing salary on a percentage of gross revenues or profits.
Once reasonable compensation has been determined, a payroll provider should be used to handle payroll payments, making the required tax deposits and filing the required federal and state payroll tax returns.
Conclusion
S-Corporations offer significant advantages for business owners, especially in terms of avoiding double taxation, reducing self-employment tax and providing limited liability protection. However, the structure requires careful adherence to tax regulations, particularly concerning shareholder compensation. When determining a reasonable salary, both quantitative and qualitative factors must be considered, including the shareholder's role in the business, the revenue generated from personal services, and industry standards.
While S-Corporations allow for tax-efficient distributions of profits, it’s essential to properly track and manage the accumulated adjustments account (AAA) and the shareholder's basis to avoid unintended tax consequences. By striking a proper balance between salary and distributions, business owners can maximize the benefits of an S-Corporation while staying compliant with tax laws.
Consulting with a tax professional is crucial to ensure that all aspects of S-Corporation taxation, including shareholder compensation and distributions, are handled appropriately. This will help businesses take full advantage of the potential tax savings while minimizing the risk of IRS challenges or penalties.