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Is Reasonable Compensation for Shareholders Really That Important? Look to Your Tax Planning Software for Guidance

Are your S corporation clients reporting shareholder payments appropriately?

The payments that S corporations make to their shareholders are important for tax planning purposes because the tax law treats some payments more favorably than others. With a good tax planning software, you can help your clients optimize their shareholder payments to reduce their tax liability while staying within the IRS’s guidelines.

Tax Consequences of Shareholders Payments

S corporation shareholder-employees are paid in two ways: (1) they are awarded distributions based on the shares that they hold, and (2) they are paid wages for performing their day-to-day work duties. When the S corporation’s shareholders are actively engaged in the business, it is not always obvious when payments should be considered distributions and when they should be considered wages. But separating the two is important because they are treated differently for tax purposes.

Tax Consequences of Distributions

Except in a few circumstances, shareholders will not need to pay additional payroll taxes on the distributions they receive. S corporations are flow-through entities, which means the entirety of the business’s earnings are taxable to the shareholders based on their ownership percentage. Receiving a portion of the business’s earnings as a cash distribution does not change the flow-through earnings they report on their tax return.

Tax Consequences of Compensation

Compensation is a bit different. Compensation is a deductible expense for the business, which reduces the overall earnings that ultimately flow to the shareholders. However, shareholder-employees are required to report their W-2 earnings from the S corporation as income on Line 1 of Form 1040.

Because the W-2 wages are deductible to the business, the shareholder-employees are not necessarily worse off by reporting their wages as income – at least from an income tax standpoint. But there is a downside to W-2 compensation from a payroll tax perspective.

Unlike cash distributions, compensation paid to shareholder-employees is subject to payroll taxes. Payroll taxes are an additional 15.3% of wages paid to the government, plus state payroll liabilities like unemployment tax and worker’s compensation. Half of all Federal payroll taxes is paid by the shareholder-employee and half is paid by the corporation. This additional tax on wages entices S corporations to pay their shareholder-employees with cash distributions rather than W-2 wages. To prevent S corporations from employing this tactic, the IRS requires that shareholder-employees be paid a reasonable compensation for the work they do.

Defining Reasonable Compensation

Reasonable compensation will never be perfectly defined. The IRS will look to many factors to determine if an S corporation is paying their shareholder-employees compensation that is reasonable:

  • The shareholder-employee’s duties and responsibilities.
  • The shareholder-employee’s level of training and experience at performing those job duties.
  • The time the shareholder-employee devotes to the business.
  • How non-shareholder employees are compensated.
  • Written compensation agreements.
  • How much a comparable business pays for similar work.
  • How, when, and in what amounts bonuses are distributed.
  • History of cash distributions to shareholder-employees.

The IRS will also consider the source of the S corporation’s earnings. S corporations’ earnings arise from the following three sources:

  1. Services of the shareholder
  2. Services of non-shareholder employees
  3. Capital and equipment

If the corporation’s earnings can be attributed to services of non-shareholder employees and/or the business’s capital and equipment, payments to the shareholders should be considered distributions. But if earnings can be directly or indirectly traced to the services of the shareholder-employees, those payments should be classified as compensation.

Loans to Shareholders

Loans to shareholders also play a role in the reasonable compensation debate.

Shareholder-employees should not be deterred from establishing a shareholder loan, but they do need to be careful. Business owners can be tempted to categorize a distribution as a loan to avoid their distribution being reclassified as compensation by the IRS.

If you see a shareholder loan on your client’s books, talk to them about it. A true loan should have the following:

A Promissory Note

There needs to be evidence that a loan exists, in writing, before the transaction occurs. If a promissory note were created after-the-fact, it may still be considered a true loan, but your client will need to explain why the promissory note was drafted late.

Appropriate Interest

The corporation should be loaning money to the shareholder at reasonable interest rates. The loan should have a stated interest rate at or above the published Applicable Federal Rate (AFR). If interest is below the AFR, the IRS could argue that the loan was not made at arm’s length and is a distribution in disguise.

Proof of Payments

The shareholder must make regular payments on their loan. If payments are forgiven or delayed, the IRS will likely see the loan as a distribution.

Recharacterizing Payments to Shareholders

If the IRS determines that an S corporation has not paid its shareholder-employees a reasonable salary, they will recharacterize a portion of distributions as compensation. Businesses will need to pay payroll taxes on the recharacterized amounts and may also be liable for late payment fees and penalties.

If your clients haven’t been sufficiently compensating their shareholder-employees, your client may be able to make catch-up compensation payments. Compensation paid in the current tax year for services rendered in the prior year may be deductible if those payments were made to correct prior year underpayments of compensation. It’s possible that your clients simply didn’t have the funds to fully compensate their shareholder-employees fully for the work that they did. This can be tricky because such drastic swings in compensation can trigger an IRS audit, but tax court precedent shows that the IRS is likely to consider these catch-up payments acceptable.

Determining Reasonable Compensation

You can help your clients avoid recharacterization of distributions by talking to them about compensation early in the process. A good tax planning software will prompt you to ask about compensation for shareholder-employees when first establishing a relationship with your client.

If your clients’ shareholder-employee compensation appears to be low, you should help them reclassify a portion of their cash distributions as wages. If you use our Corvee tax planning software, you can adjust the breakout between distribution and salary to see how their income tax liability changes. Having a dynamic software like this can help your clients make a decision that is not only likely to pass IRS reasonable compensation tests but keep their income tax liability as low as possible. If you want to see this tax planning software in action, request a demo today.

Help your clients optimize their Shareholder Payments with our Tax Planning Software.

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