How does an owner decide what is a reasonable wage and distribution? S Corporation owners are allowed to take tax-free distributions from their equity as long as there is basis. However, an S Corporation owner that provides more than minor services should be considered an employee and paid wages, which are subject to payroll and income taxes. The IRS has increased audits in this area and more S Corporation owners find their distributions being re-characterized as wages.
Two methods are used for determining reasonable compensation. The S Corporation should be prepared to defend its approach, in case of audit. Both methods utilize compensation comparability data. The statistics should be from the same industry, geographic area, and from a shareholder in a similar position. Otherwise, the methods differ greatly.
Independent investor test
The return on investment of a hypothetical owner is calculated (after all compensation is paid) and this is compared to similar companies’ returns. If equivalent, it may be considered reasonable compensation.
The number of factors addressed and the emphasis placed on each factor varies on a case-by-case basis. A primary factor is the source of revenue: was it generated by the shareholder’s services or other individuals and elements? Some other factors to consider include:
- Officer qualifications, duties and responsibilities, and time and effort devoted
- Compensation paid to other key employees and timing of their bonuses
- The company’s financial performance, size and complexity, economic conditions
What triggers the IRS to audit your S Corporation return? The IRS focuses on certain items reported on the Form 1120S and individual’s form 1040. Listed below are some items the IRS considers “red flags”:
- An improper NAICS code can cause the IRS to believe more compensation was due. This code should be evaluated annually and changed as the nature of the business changes.
- The amount of loans to shareholders on Schedule L of Form 1120S may be considered disguised compensation by the IRS if loans are unpaid for more than one year.
- The IRS can look at the treatment of S-Corp earnings on 1040 as active or passive and the occupation listed on page 2 of the 1040 and makes assumptions about what amount of wages should have been received.
For example, the nature of services provided and by whom can trigger an audit. If little or no salary was taken by an owner of a CPA firm and the owner is the only CPA performing services for the company, the IRS can determine the owner’s wages should have been greater and reclass distributions taken as wages. Even if salary was paid in an amount the CPA considered reasonable, an audit may still be triggered if staff receive similar compensation or if no raises were taken by the owner over several years of economic growth in comparison to an increase in distributions taken.
It is best to consult your tax advisor for an explanation of the benefits of taking reasonable compensation proactively and how to avoid triggering an audit of S Corporation owner compensation.