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Mary Bernard

Compensation of S Corporation Officers

A recent fact sheet issued by the Internal Revenue Service discusses treatment of employee/shareholder compensation in S corporations.

Decmeber 11, 2008
by Mary Bernard, CPA/MST

An officer of any corporation, including an S corporation, is considered an employee of the corporation for purposes of federal employment taxes. Fact Sheet 2008-25 advises corporations against treating compensation to officers as cash distributions, payments of personal expenses or loans rather than as wages to avoid employment taxes. Being an officer as well as a shareholder does not change the requirement that compensation be treated as wages, subject to employment taxes. Several court cases support the position that S corporation officer/shareholders who provide more than minor services to their corporation and who receive, or are entitled to receive, payment must be treated as employees with compensation subject to federal employment taxes.

There is an exception in the regulations where an officer would not be treated as an employee. If the officer and does not perform any services, or performs only minor services in his capacity as officer, does not receive nor is entitled to receive, any remuneration either directly or indirectly, the officer will not be treated as an employee for purposes of employment taxes. [Reg. 31.3121(d)-1(b)]

Reasonable Compensation

Form 1120S, U.S. Income Tax Return for an S Corporation instructions state: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” The amount of compensation is limited to the amount received directly or indirectly by the shareholder. However, if cash, property or the right to receive either cash or property is received by the shareholder, a salary amount must be determined and the salary level must be “reasonable and appropriate.”

No definition of “reasonable compensation” exists in the Code or Regulations. Various courts ruling on this issue have considered the following factors in their determination of “reasonableness”:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

Medical Health Insurance Premiums

When an S corporation pays health and accident insurance premiums for a two-percent shareholder/employee, the premiums are deductible by the corporation as fringe benefits and includible in the wages reported on Form W-2 of the shareholder/employee. The payments are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. The amount paid is included in Box 1 of Form W-2 of the shareholder/employee.

In determining the proper treatment of fringe benefits, a “two-percent shareholder” is any person who owns (or is considered to own under the constructive ownership rules of IRC section 318), on any day during the S corporation’s taxable year more than two percent of the outstanding stock of the corporation or stock possessing more than two percent of the total combined voting power of all stock of the corporation. [IRC section 1372(b)]

If the medical care coverage is established by the corporation, the two-percent shareholder may deduct the amounts paid during the year for medical care premiums from adjusted gross income. Until this year, “established by the corporation” was interpreted to mean that it was required that the medical coverage be issued in the name of the S corporation. Notice 2008-1 provides that if the medical coverage plan is in the name of the two-percent shareholder rather than the corporation, a medical care plan can be considered to be established by the S corporation if it paid or reimbursed the two-percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the two-percent shareholder’s Form W-2. The position in this notice contradicts guidance on this issue posted on the IRS Web site during 2006.

The Fact Sheet concludes with the advice that the payment of health and accident insurance premiums on behalf of the shareholder should not be reported on Schedule K-1 or Form 1099 as an alternative to reporting such payments as additional compensation on Form W-2.

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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.