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S Corporation Profits or Payday?

While no perfect formula exists, CPAs can be sure the IRS is on the lookout for S corporations that underreport salaries to shirk FICA and FUTA taxes.

September 2007
from Journal of Accountancy

The IRS is on the lookout for S corporations that fail to pay reasonable salaries to shareholders who perform services for the corporation. The failure to pay adequate salaries — or any salary at all — to shareholder-employees (SEs) is a “red flag” for an audit. CPAs need to advise their small business clients on how to properly classify payments to shareholders so they don’t face a bigger employment tax bill down the road — with interest and penalties to boot.

More Art Than Science

When corporations elect subchapter S status, the IRS sends out a notice to shareholders reminding them that SEs must be paid reasonable salaries. The notice also states that the IRS can reclassify as salaries any distributions to the shareholders. This statement has been sent out since 2005, about the time the IRS determined that it needed to curb abuse of the reasonable-salary rule. Determining what a reasonable salary is may be more art than science, but the attempt must be made.

Because the IRS’s goal is to collect Federal Insurance Contributions Act (FICA) tax on the salaries, one solution is to pay the maximum amount of wages subject to Old Age, Survivors and Disability Insurance (OASDI, or Social Security) tax, assuming of course this is a reasonable salary, based on the SE’s services actually rendered. The maximum salary subject to OASDI in 2007 is $97,500. (All wages, without limit, are subject to the other component of FICA, Medicare tax.) This may be appropriate for a shareholder in a full-time executive role, such as CEO or controller, assuming similarly situated executives aren’t paid significantly more in competitive businesses.

[READER NOTE: Read full article with valuable tips and tables here.]

A smaller salary may be justified for a lower-ranking SE, or even an executive in a startup or a relatively small corporation. The corporation could also examine comparable wages within its industry by consulting trade publications. The salary should also consider the SE’s experience and skill, the geographic region, customer base, number of employees and time committed to the corporation. What is a reasonable salary depends on the facts of each case. No test is conclusive. It often becomes a judgment call by the IRS.

Furthermore, the IRS has not published criteria to determine what a reasonable SE salary or salary range might be for various positions in a given industry. Comparable salaries from industry data are usually appropriate. The CPA can use search engines on the Internet to find just about any type of salary in any industry for given regions.

In at least one instance, the Tax Court allowed statistical data from an industry and region to be used as guidance for reasonable compensation (Wiley L. Barron v. Commissioner, TC Summary Opinion 2001-10). Barron, an Arkansas CPA, was the sole shareholder and CEO of an S corporation. In 1994, the S corporation paid him a salary of $2,000. No salary was paid in 1995 or 1996. He received cash distributions in 1994, 1995 and 1996 of $56,352, $53,257 and $83,341, respectively. The Tax Court accepted the analysis of an IRS consultant, who estimated that reasonable compensation for a CEO of an Arkansas CPA firm of similar size for those years was $45,000, $47,500 and $49,000.

The 60-40 Approach

Many CPAs advise their clients to use what is called the “60-40 rule.” First, the reader should be cautioned that this is not an IRS rule. It was developed by practitioners as a simple guide for determining a reasonable salary. The IRS has not published any statement that this is a “safe harbor” for salary payments to the SE. No regulatory or judicial authority backs up the 60-40 rule. Therefore this article will use the phrase “60-40 approach” to describe the practice.

Under a 60-40 approach, the split between salaries and distributions should be 60 percent for salaries and 40 percent for distributions. For example, assume that Ted is the sole SE in his profitable S corporation, working full time as its CEO. During the year he takes $70,000 in distributions from the corporation. His salary should be 60/40 X $70,000 = $105,000. This is one interpretation of the 60-40 approach, but consider the following possibility. Suppose Ted does not take any distributions from the corporation. Instead, he “plows back” the earnings into the corporation for future needs. Does this mean he does not have to take any salary? Certainly not. If a reasonable salary is $105,000 when there are distributions, then a reasonable salary is $105,000 when there are no distributions. Also, why use a 60-40 split? Why not a 50-50 or 70-30 split? The 60-40 approach is an arbitrary rule, and CPAs should understand that.

A more logical rule is to make the salary a percentage of the net business income of the S corporation before considering the salary deduction, for example, between 30 percent and 40 percent. Suppose Alice is the sole SE of her S corporation and is its full-time CEO. Before deducting her own salary, the net business income of the corporation is $100,000. A reasonable salary for her might be $40,000 in these circumstances, regardless of her distributions. Again, this is a mere suggestion. One could also base the SE salary on a percentage of gross revenue, since that indicates better than net income the extent of the SE’s activity and responsibilities.

Be Wary of Inflexible Rules

Using something like a 60-40 approach is better than nothing, in that it should prevent the S corporation from paying no salary to the SE and thus triggering an audit. But keep in mind that the base for any percentage approach is likely to change dramatically from year to year, thus creating wide salary disparities. For example, suppose Jorge is an SE who takes $50,000 in distributions from his S corporation in year one and $80,000 in year two. In both years he devotes the same amount of time to the corporation. Is a year one reasonable salary 60/40 x $50,000 = $75,000 and a year two reasonable salary 60/40 x $80,000 = $120,000? Of course not. A similar conclusion applies even if the percentage is based on net business income before the SE salary. This too could fluctuate greatly.

The point is that no IRS rule insulates the S corporation from an audit on this issue. A reasonable salary depends on all the facts and circumstances in each individual case, and CPAs should be wary of becoming addicted to any hard-and-fast “rule” just because many other practitioners use it. For example, if the S corporation is a personal service corporation with one employee, the SE, then a case can be made that the entire net earnings of the corporation should be salary. At the other extreme, if the S corporation is a construction company with large amounts of capital equipment, then a good deal of the corporate earnings are a return on this capital. A reasonable salary in that case may be just 20 percent of the corporate earnings. Even then the CPA is reminded that this is only an educated guess not supported by any sophisticated analysis.

Conclusion

The CPA must be very careful when working with S corporation clients to determine reasonable salaries for the SEs. If not, the IRS could view any type of distribution as a disguised salary. The CPA should advise clients to consider and document all factors used to determine salary or other compensation for an SE. CPAs should also urge clients to conduct a compensation survey or other similar study, particularly if an SE seems to be in the lower end of the compensation continuum for the corporation’s size, industry, region and other factors.

CPAs conducting a survey for the express purpose of determining a reasonable salary are cautioned to suggest ranges as well as a host of factors that would alter the actual amount that would be reasonable or cause an SE to fall outside the ranges. CPAs might recommend employment agreements that embody these factors. But they should not depend on them to save the day in such circumstances, because they are not considered arm’s-length agreements within a closely held corporation.

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James A. Fellows, CPA, Ph.D., is a professor of accounting and John F. Jewell, CPA, J.D., L.L.M., is a lecturer in accounting and law, both at the University of South Florida, St. Petersburg. Their views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.