December, 2006 Tax Newsletter

Warning to S Corporation Owners – Pay Yourself a Reasonable Salary

The IRS has been applying heat to S corporations (“S corp”) by significantly stepping up the number of audits.  The IRS has stated that it’s primary focus is on companies that have paid little or no salary to owner/employees as a way to evade federal employment taxes.  The IRS is also targeting S corps that are subject to the hobby-loss rules.

One of the major tax advantages an S corp has over sole proprietorships and limited liability companies (“LLCs”) is in the area of FICA and other employment taxes.  S corporations must pay a “reasonable” salary to officers of the corporation who are also employees of the corporation.  The salary is subject to withheld employment taxes which take over 15% of total salary.  The amounts held back go toward the employee’s Social Security and Medicare.  If reasonable salaries have been paid, amounts in excess of those salaries can be paid out in distributions that are not subject to employment taxes.

The IRS is aware that many S corps abuse the S corporation privilege by paying little or no salary to active officer-shareholders, even though the corporations may have earned substantial profits.  Instead they pay distributions to the officer-shareholders which are free of employment taxes.  In fact, the IRS has stated that no one works for free and, therefore, officers of the corporation must receive reasonable wages even if the business is losing money.  Whether this IRS contention would hold up during the early years when many new corporations have losses is questionable.  Personally, I am in the camp of those tax advisors who take the position that, as long as employment-tax-free distributions are not being made, salaries do not need to be paid.  If distributions are made before salary is paid, I think the company would be skating on very thin ice.

So what is a reasonable salary?  It seems clear that compensation of shareholder-employees should be based on the same criteria used for non-shareholders.  Therefore, factors would include such items as prevailing market rates; the individual’s knowledge, skills, and abilities and hours worked.  If a non-shareholder would accept the position at the proposed salary, the salary is most likely reasonable.

With regard to the IRS’ attack on hobby losses, the rule for an S corp is the same as for an individual.  (See “Is Your Business Really Monkey Business?”, February, 2004 Tax Newsletter, at my website, www.rontaxcpa.com.)  A business is presumed to be engaged in for-profit if it shows positive net income in three years out of a five year period.  That means an S corp should plan on having no more than two loss years in any five-year period.  However, S corps might be able to prove they have a profit motive even though they have more than two years of losses if they can show increasing sales, maintain expenses, and project a profit in the near future.