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s corporation reasonable officer compensation

S Corporation Reasonable Officer Compensation

All audio is streamed through your computer speakers.

There were  several attendance verification questions presented during the LIVE webinar to qualify for CPE of the LIVE event only.

For the archived/recorded version of this webinar, the link at the end of this presentation will be to final exam on the topics and learning objectives covered during this webinar plus there are also 3 online  review questions to answer per hour.

learning objectives
Learning Objectives

Upon completion of this webinar you will be able to:

  • Recognize who qualifies to be an officer of an S Corporation and if they receiving "reasonable" compensation.
  • Identify the various methods that can be used to determine what is reasonable and the consequences of unreasonable compensation.  
  • Determine how the government picks their labor audits. 
  • Identify what is unreasonable salary and what is unreasonable salary for SSA.
  • Classify who is an employee.
  • List nine factors used by courts.
  • Identify factors used to determine compensation.
eye catching statistics

Eye Catching Statistics!

In 2005 Treasury Inspector General for Tax Administration (TIGTA) issued a report

Analyzed S Corporation returns filed in 2000

About 80% of all S Corps were more than 50% owned by ONE shareholder

Single-shareholders of S Corps paid themselves about 41.5% of corporate profits, declined from 47.1% in 1994

eye catching statistics1

Eye Catching Statistics!

36,000 Single-shareholder of S Corps generating over $100,000 of income too ZERO salaries, passing through $13.2 Billion to shareholders Free of payroll taxes

Total payroll taxes by single-shareholder S Corps were $5.7 Billion less than if they were taxed as sole proprietors

eye catching statistics2

Eye Catching Statistics!

In 2009, U.S. Government Accountability Office (GAO) reported to Senate Committee on Finance

In 2003 & 2004 combined, S Corporations underreported their shareholder compensation by $24.6 Billion

The responsible corporations had fewer than Three shareholders responsible for almost all underreporting

reasonable compensation
Reasonable Compensation
  • The IRS has recently indicated there will be audit initiatives for S Corporation officer compensation
  • Lack of shareholder compensation on an 1120S tax return is a major “red flag”
  • Andrew has already experienced it!
  • Rev. Rul. 74-44,1 – IRS may recharacterize dividends as wages
reasonable compensation1
Reasonable Compensation
  • S Corporation shareholders think “No Double Taxation” means “No Payroll Taxation”
  • S Corporations are pass-through entities, however there Must be reasonable compensation
  • Lack of officer compensation is a disaster not a savings!
what is unreasonable salary
What Is Unreasonable Salary?
  • Zero salary is unreasonable
  • Nobody works for FREE!
  • Salary below minimum wage is unreasonable
  • Salary in excess of appropriate wage is also unreasonable
what is reasonable salary
What Is Reasonable Salary?
  • This is the million dollar question!
  • IRC states distributions and other payments to a corporate officer for services must be treated as wages
  • There are no specific guidelines for reasonable compensation, thus allowing abusive practices by S Corps
taxpayers love unreasonable compensation
Taxpayers Love Unreasonable Compensation
  • S Corporation dividend distributions are Not subject to Self-Employment Tax (SECA)
  • Not subject to Federal Unemployment Tax (FUTA)
  • Not subject to State Unemployment Tax (SUTA)
taxpayers love unreasonable compensation1

Taxpayers Love Unreasonable Compensation

Taxpayer saves the following

7.65% in employer portion of FICA

7.65% in employee portion of FICA

Federal Unemployment (FUTA)

State Unemployment (SUTA)

Are the savings worth the risk?

irs loves unreasonable salary
IRS Loves Unreasonable Salary
  • IRS won’t hesitate to recharacterize distributions to compensation
  • Penalty for failing to pay employment taxes is 100% of taxes owed, and may lead to Trust Fund Penalty!
  • Penalties are not tax deductible
  • They add up quickly & IRS loves it!
ssa loves unreasonable compensation
SSA Loves Unreasonable Compensation
  • Social Security Administration (SSA) is concerned with S Corp Officer Compensation
  • Can recharacterize dividend distributions to compensation
  • Can reduce Social Security benefits
fs 2008 25
FS-2008-25
  • IRS issued Fact Sheet-2008-25 – August 2008 (Warning for S Corporation shareholders)
  • FS-2008-25 reiterated the factors to be considered for determining reasonable compensation
  • Outlines that corporate officers are employees for FICA, FUTA, Federal Income Tax under the IRC
when should there be payment
When Should There Be Payment?
  • When services are performed for the corporation; and
  • Shareholder receives or is entitled to receive payment;
  • The compensation is considered wages; and
  • It is taxable for federal employment taxes
who is an employee
Who Is An Employee
  • Shareholders are employees if they perform services
  • Can they perform different types of services?
  • Can there be different levels of compensation?
  • What are the determining factors for compensation?
9 factors considered by courts
9 Factors Considered by Courts
  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
9 factors considered by courts1
9 Factors Considered by Courts
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of formulas to determine compensation
factor 1 training and experience
Factor 1 - Training and Experience
  • What type of training does shareholder-employee have?
  • What type of experience does shareholder-employee have?
  • What level of education does shareholder-employee have?
factor 2 duties and responsibilities
Factor 2 - Duties and Responsibilities
  • What type of duties does shareholder-employee have?
  • What is he/she responsible for? (Management, daily operations, clerical)
  • How do the duties and responsibilities compare to other employees in the business?
factor 3 time and effort devoted
Factor 3 - Time and Effort Devoted
  • How much time is dedicated to the business?
  • Is documentation available for the various duties performed?
  • Is the time devoted for major or minor services?
factor 4 dividend history
Factor 4 - Dividend History
  • Is there consistency in issuing dividend payments?
  • How often are dividends paid?
  • How much is each dividend payment?
  • Is there a formula used to compute dividends?
factor 5 payments to non shareholder employees
Factor 5 - Payments to Non-Shareholder Employees
  • Does business have non-shareholder employees?
  • What type of services do non-shareholder employees perform?
  • How do they get compensated?
  • How often do they get compensated?
factor 6 timing manner of bonus payments to key employees
Factor 6 - Timing & Manner of Bonus Payments to Key Employees
  • Do all or some employees receive bonus payments?
  • If so, how often are bonuses paid?
  • How are they determined? Is a formula used?
  • Are they performance based, or position based?
factor 7 what do competitors pay for similar services
Factor 7 - What Do Competitors Pay For Similar Services?
  • What do other businesses in the industry pay for similar services?
  • What do other businesses in the local vicinity pay for similar services?
  • How does shareholder’s compensation compare to competitor’s and industry?
factor 7 what do competitors pay for similar services1
Factor 7 - What Do Competitors Pay For Similar Services?
  • Check competitor and industry compensation regularly
  • Checkwww.Salary.com & www.Monster.com
  • Salaries and compensation change as economic climate changes
  • Would your competitor hire you for what you pay yourself?
factor 8 compensation agreements
Factor 8 - Compensation Agreements
  • Are compensation agreements used with non-shareholder employees?
  • Is there a compensation agreement executed by shareholder-employee?
  • Does compensation agreement clearly outline duties, responsibilities, wage compensation, and dividend distributions?
factor 9 using formulas to determine compensation
Factor 9 - Using Formulas To Determine Compensation
  • Are formulas used to compute compensation for shareholder-employee?
  • Is it the “60-40” Rule?
  • Is the formula used consistently?
  • Does it provide for reasonable compensation?
review questions for self study cpe

Review Questions for Self-Study CPE

Now’s the time to answer the review questions.

Follow this link:

http://www.proprofs.com/quiz-school/story.php?title=NTc1ODky

Please leave quiz window open and wait to submit until prompted to complete questions 4 through 6. Once completed, press Submit and close quiz window.

amazing doggy day care center case study 1

Amazing Doggy Day Care Center- Case Study 1

Fact’s for IRS S Corporation Office Compensation audit

Julie Jones (mother) & Amanda Jones (daughter) owned and operated Amazing Doggy Day Care Center, a business in Atlanta, GA from 2005-2010

Business sold in September 2010

Taxpayer audited by IRS for employment taxes for tax year 2010 in 2012

amazing doggy day care center case study 11

Amazing Doggy Day Care Center- Case Study 1

Amazing Doggy Day Care gross revenues in 2010 were over $550,000

Amazing Doggy Day Care net profit was $91,000

Business had a staff of 20 employee’s ranging between $8.00 to $16.00 per hour

Julie paid herself $28,000 in officer compensation for

Amanda paid herself $1,000 in officer compensation

amazing doggy day care center case study 12

Amazing Doggy Day Care Center- Case Study 1

Can you successfully represent this taxpayer?

What facts do you feel are a detriment to the taxpayer?

What facts do you feel can help the taxpayer win this case?

Are there other things we should look at in preparation of this audit?

amazing doggy day care center case study 13

Amazing Doggy Day Care Center- Case Study 1

Who won this examination?

The IRS, or

Amazing Doggy Day Care Center

other factors to consider
Other Factors to Consider
  • Health and accident insurance premiums
  • Loans between corporation and shareholder
  • Expenses paid by shareholder using personal funds
  • Income allocation to family members
health accident insurance premiums
Health & Accident Insurance Premiums
  • Does business pay health & accident premiums on behalf of greater than 2% shareholder-employee?
  • Is coverage in the business or shareholder’s name?
  • Are the payments reported on shareholder’s W-2?
health accident insurance premiums1
Health & Accident Insurance Premiums
  • Greater than 2% shareholder premium payments should be reported on W-2
  • Not taxable for FICA or FUTA taxes
  • Mandatory reporting on W-2 effective January 2013
health accident insurance premiums2
Health & Accident Insurance Premiums
  • Notice 2008-1 – Revised regulations for health coverage plans. Policy doesn’t have to be in S Corporation name
  • Still deductible even if health coverage is in 2% shareholder’s name. It’s considered to be established by S Corporation
  • S Corp can pay health insurance premiums or reimburse shareholder and take deduction
atlanta data center case study 2

Atlanta Data Center – Case Study 2

Georgia Department of Labor audit conducted in 2012 on Atlanta Data Center, a service based business for tax year 2011

Facts of the case are as follows

Atlanta Data Center has been in operating since 2000

Owned by a single-shareholder David Sanders in 2011

David Sanders sold 60% share to Tom Price a wealthy billionaire in 2012, for $3.6 million

atlanta data center case study 21

Atlanta Data Center – Case Study 2

Business gross revenues in 2011 were $4.3 million

Business net income in 2011 was $1.2 million

David Sanders paid himself a salary of $172,000 in 2011

He received distributions of $440,000 in 2011

The S Corp paid for his health insurance of $14,600

David’s percentage of salary to distributions is 28%

atlanta data center case study 22

Atlanta Data Center – Case Study 2

Can you successfully represent this taxpayer?

Who is our client, David Sanders, Tom Price, or both?

Are there any ethical dilemmas in this case?

What will you use to represent Atlanta Data Center against the GA Department of Labor?

Do we have any other concerns in this case?

atlanta data center case study 23

Atlanta Data Center – Case Study 2

Who won this audit?

The Georgia Department of Labor, or

Atlanta Data Center

shareholder loans
Shareholder Loans
  • Shareholder loans are allowable
  • Must be repaid with Reasonable Interest
  • Paying interest legitimizes loan as Arms-Length transaction
  • Not paying interest can be construed as Capital Contribution
shareholder loans1
Shareholder Loans
  • Loans must be in writing – Formal Note between corporation and shareholder
  • Reasonable interest must be paid
  • Compare interest rates from local banks to get market rate
  • Interest expense is deductible for the business
shareholder loans2
Shareholder Loans
  • No interest can be construed that debt is contingent upon corporate profits
  • Debt contingent upon corporate profits is considered a second class of stock
  • Second class of stock terminates S Corporation Election!
  • Busting up S Corp turns it to C Corp – Double Taxation!
expenses paid by personal funds
Expenses Paid by Personal Funds
  • Expenses paid with shareholder’s personal funds should be reimbursed with company check
  • Expense reimbursement form should be completed for documented expenses
  • Expenses charged on shareholder’s personal credit card should be well documented
income allocation to family members
Income Allocation to Family Members
  • Shifting S Corporation income to family member shareholders in a lower tax bracket
  • Helps reduce tax liability for shareholder
  • Great for estate tax planning, but not great for shareholder compensation issues
  • IRC Section 1366(e) – Gives IRS authority to make adjustments
hobby loss issues
Hobby – Loss Issues
  • Is there a reason why business can’t compensate shareholder for services year after year?
  • Is the shareholder not getting compensated because business is a hobby; or
  • Because the owner is a bad business person and can’t turn a profit?
s corporation court cases
S Corporation Court Cases
  • Roob vs. Commissioner(Court upheld IRS reallocation of dividends – Taxpayer failed to present evidence salary was reasonable)
  • Rocco vs. Commissioner(Court ruled in favor of taxpayer – Salary was reasonable even with large dividends)
  • Davis vs. Commissioner(Court ruled in favor of taxpayer using comparability test – Paid comparable salary to industry)
s corporation court cases1
S Corporation Court Cases
  • Ludeking vs. Finch(Court ruled in favor of SSA to reclassify dividend distributions)
  • Herbst vs. Finch(Court ruled in favor of taxpayer – SSA couldn’t reclassify salary)
  • Weisenfeld vs. Richardson(Court ruled minor wages were not substantial services –SSA lost)
s corporation court cases2
S Corporation Court Cases
  • Bianchi vs. Commissioner(Court ruled compensation was excessive – reduced pension contribution)
  • Joseph Radtke vs. U.S.(Court ruled no salary was paid by Attorney – shareholder)
  • Spicer Accounting vs. U.S.(Court ruled no salary paid by Accountant - shareholder)
s corporation court cases3

S Corporation Court Cases

Veterinary Surgical Consultants, P.C. vs. Commissioner(Tax Court ruled employer can’t avoid federal taxes by characterizing compensation paid to sole shareholder as distributions)

Joly vs. Commissioner(Court ruled that shareholder-employee used company bank account for personal use. Ruled that employment taxes were owed on personal use money)

Joseph M. Grey Public Accountant, P.C. vs. Commissioner(Court ruled that dividends were actually wages subject to employment taxes)

david e watson p c s corporation court case

David E. Watson, P.C. - S Corporation Court Case

David E. Watson, P.C. vs. Commissioner (Accounting Case)

David Watson, CPA formed David E. Watson PC (DEWPC), and Iowa professional corporation electing to be taxed as S Corp

Under an employment agreement with DEWPC, David provided exclusive accounting expertise to accounting firm which he had formerly been a partner.

david e watson p c s corporation court case1

David E. Watson, P.C. - S Corporation Court Case

In 2002 & 2003, DEWPC paid Watson a salary of $24,000 each year and distributions of $203,651 in 2002 and $175,470 in 2003.

IRS challenged the distributions and assessed FICA taxes, penalties, and interest. DEWPC took case to tax court

Who won in this case?

david e watson p c s corporation court case2

David E. Watson, P.C. - S Corporation Court Case

District Court ruled against DEWPC – stated $24,000 per year salary was “less than credible”

It accepted the IRS recharacterizing distributions of $91,044 to salary.

Damaging facts were that David had 20 years experience, was primary revenue producer for firm, worked 35-45 hours per week, firm was well-established

case study sanders corp
Case Study – Sanders Corp
  • $100,000 in W-2 Wages
  • Employer FICA @ 7.65% $7,650
  • Employee FICA @ 7.65% $7,650
  • Total Tax Liability $15,300
  • $10,000 in W-2 Wages/$90,000 in Distributions
  • Employer FICA @ 7.65% $765
  • Employee FICA @ 7.65% $765
  • Total Tax Liability $1,530
case study sanders corp1
Case Study – Sanders Corp
  • Tax Liability – Situation 1 $15,300
  • Tax Liability – Situation 2 ($1,530)
  • Tax Savings in Situation 2 $13,770
  • Which would you recommend if your client asked for advice?
case study jones printing inc
Case Study – Jones Printing Inc
  • “60-40” Rule - Danny Sole Shareholder
  • Services provided by Danny
  • Profits $100,000 (Are distributed)
  • 60% Salary - $60,000
  • 40% Distributions - $40,000
  • Is this reasonable compensation?
case study jones printing inc1
Case Study – Jones Printing Inc
  • “60-40” Rule – Danny Sole Shareholder
  • Services provided by Danny
  • Profits $100,000 (Not Distributed)
  • 60% Salary - $60,000
  • Should Danny take $60,000 salary if no earnings are distributed?
tax implications of reclassification
Tax Implications of Reclassification
  • Penalties from reclassification are not deductible
  • Higher taxes for IRS if distributions are reclassified
  • Amended 1120S and 1040 will be required
  • Higher scrutiny if future years
case study home crafters inc
Case Study – Home Crafters Inc
  • $90,000 Net Profit – No Salary Paid to Melissa
  • Melissa provides services to Corporation
  • $50,000 Distributions Paid to Melissa
  • Employer FICA Savings @ 7.65% $3,825
  • Employer FUTA Savings @ 6.2% $ 434
  • Melissa’s FICA Savings @ 7.65% $3,825
  • Total Savings $8,084
case study home crafters inc1
Case Study – Home Crafters Inc
  • IRS Audits and reclassifies $50,000 of distributions Melissa received
  • New Net Profit to Report on 1120S after reclassification
  • Net Profit before Reclassification $90,000
  • Less: Salary Payment ($50,000)
  • Less: Payroll Taxes ($4,259)
  • Net Profit on 1120S Post Reclassify $35,741
case study home crafters inc2
Case Study – Home Crafters Inc
  • Melissa’s total income on her 1040 after reclassification
  • Net Profit $35,741
  • Salary $50,000
  • Total Income $85,741
  • Assume Melissa is in 28% tax bracket. She will pay $1,193 less in income taxes ($4,259 x 28%)
case study home crafters inc3
Case Study – Home Crafters Inc
  • Melissa pays $1,193 less in income taxes
  • However, U.S. Government collects $6,891 more in payroll taxes
  • Total Payroll Taxes–S Corp/Melissa $8,084
  • Less: Melissa’s lower income tax ($1,193)
  • Net Increase in Taxes due IRS $6,891
suggestions for reasonable compensation
Suggestions for Reasonable Compensation
  • Distributions should be recorded in corporate minutes
  • Distribution payments should be stated as a dollar value per share owned by shareholder
  • Don’t make frequent distributions (Monthly)
  • Distributions paid to all shareholders on same date
suggestions for reasonable compensation1
Suggestions for Reasonable Compensation
  • Do Not pay personal bills through business and “call” them distributions
  • Pay reasonable wages using comparable salaries with industry and position
  • If business is losing money, don’t put borrowed money into business and pay it as distributions
reasonable compensation2
Reasonable Compensation
  • Always provide your client the worse case scenario figures
  • Let them know in advance that it’s costly to not be Reasonable with the IRS!
  • Be Reasonable – Stay Out of Trouble!
review questions for self study cpe1

Review Questions for Self-Study CPE

Now’s the time to answer the review questions.

Follow this link:

http://www.proprofs.com/quiz-school/story.php?title=NTc1ODky

Please finish the remaining review questions and press Submit. Once submitted, please close the review questions window and continue to next slide.

thank you for participating in this webinar below is the link to the online survey and cpe quiz

Thank you for participating in this webinar.Below is the link to the online survey and CPE quiz :

http://webinars.nsacct.org/postevent.php?id=10803

Use your password for this webinar that is in your email confirmation.

You must complete this survey and the quiz or final exam (for the recorded version) to qualify to receive CPE credit.

National Society of Accountants

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Alexandria, VA 22314-1574

Phone:  (800) 966-6679

members@nsacct.org