If you are a shareholder in an S Corporation and you also work for that S Corporation, it is critical that that you pay yourself a reasonable wage. Many S Corporation owners take little or no compensation in the form of wages and, instead, disproportionately pay themselves in the form of distributions. This can lead to costly consequences, and can also wreak havoc in the event that the S Corporation winds up in collections with the IRS. It can also cause trouble in an audit or even cause the IRS to initiate an audit. This article will explore the issue of reasonable wages for S-Corp owner/employees, explain the potential consequences for such an owner/employees failing to take reasonable wages, and provide guidance on how to avoid falling into this common trap.
Reasonable Wages for a S Corporation Owner or Employee
First, it is necessary to understand whether an S Corporation shareholder is also an employee under the law. Under Section 3401(c) of the Internal Revenue Code, an employee is defined to include an officer of a corporation. Almost all S Corporation owners are, to at least some degree, actively engaged in running their corporation, and very frequently fulfill the role of an officer. Even if the shareholder is not an officer, if he or she provides employee-like services to the S Corporation, there is a good chance that the law will consider that shareholder an employee. Consequently, a very high percentage of S Corporation shareholders are also employees of the S Corporation. Also, keep in mind that the shareholder cannot simply proclaim non-employee status. While this is an oversimplification, a rough guideline would be “if the owner does the duties of an employee or officer, she is an employee.”
The tax code requires that employers pay employees wages as compensation, and a percentage of those wages must be withheld for Federal Income taxes, Social Security and Medicare (see Internal Revenue Code Section 3111). Further, the employer must match the amounts withheld from an employee’s paycheck for Social Security and Medicare.
Distributions of the S Corporation’s profits, on the other hand, are not subject to these withholdings. Rather, the profits of the S Corporation flow through to its shareholders and are taxed as ordinary income on the shareholders’ individual income tax returns. Thus, in the context of compensating an S Corporation owner/employee, there are generally more overall taxes associated with wages than there are with distributions. This makes it tempting for the owner of an S Corporation to pay as little as possible to himself in the form of wages, and instead take much or all of his income from the corporation in the form of distributions, thereby avoiding the Social Security and Medicare withholdings and avoiding the employer matching components on his distributed income.
It is important to note that there is nothing wrong with distributions per se. However, if an owner/employee fails to take reasonable wages for services rendered, then the distributions that the officer took–up to the amount that would be considered reasonable wages–can be reclassified by the IRS as wages. This will result in a tax liability for the S corporation plus penalties and interest.
To illustrate, let’s say that over the course of a year, the sole shareholder of an S Corporation receives $100,000 in wages from the S Corporation, and that after paying these wages and all other expenses, the company breaks even (has no net income and no loss). For the purpose of this illustration, I am disregarding income tax withholdings, as the owner/employee must pay income tax whether the moneys come in the form of wages or distributions.
Whereas the $100,000 was paid in the form of wages, the amount required to be withheld from the owner/employee’s paychecks for Social Security and Medicare would be $7,650 (6.2% Social Security + 1.45% Medicare). On top of this, as the employer, the S Corporation must also pay a matching portion of $7,650. In this example, the total paid for Social Security and Medicare on the compensation is $7,650 (Employee withholding) + $7,650 (Employer portion.) = $15,300. Note that the S Corporation would also have to pay for FUTA, Unemployment Taxes–a relatively small amount, but more money out of pocket nonetheless.
Now, let’s take the same example and see what would happen if the S Corporation paid no wages to the owner/employee. Recall that the company broke even when it paid $100,000 in wages to the owner/employee. Since, the S Corporation now isn’t paying any wages to the owner/officer, it will not have the following expenses: $100,000 (wages to owner/employee) + $7,650 (employer matching for employee/owner) = $107,650. Without those expenses, the corporation will now have net income of $107,650, which could be distributed to the owner/employee. The effective result is that the employer/owner winds up with $7,650 more income than he would have had if he took wages plus an extra $7,650 that was not withheld from his “paychecks” for Social Security and Medicare. This, in and of itself, has the effect of putting an extra $15,300 in the owner/employee’s pocket. True, the owner/employee will have an additional $7,650 in taxable income. However, even if the owner/employee had to pay $2,500 in income tax on that additional $7,650, he still comes out ahead by $12,800 ($15,300 extra money – $2,500 in additional income tax).
Although the result of taking distributions instead of wages may sound enticing for the S-Corp owner/employee, there are a number of potentially serious consequences for taking this approach. First, it is illegal under the tax laws. Second, it could prompt or increase the chances of an audit. Third, there is a potential for a hefty negligence or even fraud penalty. Fourth, once the IRS realizes what the owner/employee did, it will very likely reclassify some or all of the owner/employee’s distributions as wages. This will result in 941 and 940 (employer withholding tax) liabilities for the S Corp, plus penalties and interest.
Finally, should the S-Corp wind up in collections with the IRS for any kind of unpaid taxes, the failure to pay reasonable wages to the owner/employee could prevent the S-Corp from being eligible for tax resolution strategies such as an Installment Agreement or an Offer in Compromise. If a business in collections with the IRS is not eligible for a tax resolution strategy, the result is often enforced collections such as bank levies, accounts receivable levies, and the seizure of assets. This can ultimately lead to the demise of the business, and financial ruin for the owner/employee. Thus, taking unreasonably low wages is a very risky business, and should be avoided.
This raises the question: What amount of wages for the owner/employee would be considered reasonable? The tax code does not specifically state what an S-Corp owner/employee’s wages should be, and, unfortunately, this can often be a gray area.
There are court decisions that shed some light into this gray area. In one such case, the IRS reviewed the wages and distributions of an accountant. The accountant who was the sole shareholder, officer and employee of the corporation paid himself $24,000 in wages and $200,000 in distributions. For an accountant, the wages appeared to be too small, especially in relation to the total income. The IRS determined that the fair market value of his services should have been $91,000, not $24,000 and therefore reclassified $67,000 worth of distributions as wages.
The Court in Watson, P.C. v. U.S., (CA8 02/21/12) 109 AFTR 2d ¶ 2012-483 listed several factors to be considered in making the determination that his wages were too low and that some of the distributions should have been characterized as wages:
• 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; and
• Use of a formula to determine compensation.
I would also recommend that S-Corp owner/employees ask themselves the following questions:
1. Are the wages paid equivalent to the fair market value of your services? What would you have to pay someone else to do your job? What do employees who fulfill a role similar to yours at competing companies get paid?
2. How qualified are you in the type of work you do for the company? How much experience do you have? The more qualified and experienced you are, the higher the wages should be.
3. How many hours per week do you work for the company? The more time you spend working for the company, the higher your wages should be.
4. Are the wages paid relatively low compared to other officers or owners that do the same thing you do?
5. What is the ratio of wages to distributions paid? If distributions are a lot higher than wages, then you should be prepared to make a strong defense that the wages you pay yourself are reasonable.
Even with the above guidance, this is still a murky area. Oftentimes, an owner/employee will not be able to nail down “reasonable wages” with pinpoint accuracy, and will, instead, come up with more of a ball park figure. For example, reasonable compensation for a particular owner/employee might be somewhere between $70,000 on the low end, and $110,000 on the high end. If that is the case, then the individual’s tolerance to risk will come into play. In this $70,000-$110,000 example, I would say that wages from 0-$50,000 would be extremely risky, wages from $50,000-$70,000 would be high risk, wages from $70,000-$90,000 would be moderately risky, wages from $90,000-$110,000 would be low risk, and wages over $110,000 would be almost no risk.
Finally, it is a good idea to seek advice from a qualified tax professional. Just be careful. I’ve had an astonishingly high number of S-Corp owner/employee clients whose CPA advised them not to pay themselves wages (while taking distributions instead). If you are an S-Corp owner/employee and your CPA has given you such advice, consider terminating your relationship with your CPA and get a second opinion. If you are taking significant distributions and no wages, the IRS likely will not be lenient with you even if you were following the advice of a professional. If, on the other hand, you are paying yourself wages that are at least arguably reasonable and the amount of those wages was recommended to you by a tax professional, I would expect the IRS to be relatively lenient if it starts to analyze the reasonableness of your wages and determines that your wages are too low.