As an S Corporation, one of the best ways to minimize taxes is by compensating shareholders fairly. This article reviews setting appropriate compensation levels for your S Corp in 2024.
S Corporation Compensation đź’°
S Corporation compensation requirements are often misunderstood and misused by owner-shareholders.
An S Corporation is a type of business structure where the business doesn’t pay income tax at the corporate level. Instead, it passes income, gains, losses, and deductions to the shareholders for inclusion on their income tax returns. If there are gains, these distributions are seen as a return on investment and are not subject to self-employment taxes.
Reasonable Compensation in an S Corp đź’¸
If shareholders also work in the business, they should take reasonable compensation for their services as wages. Wages are subject to FICA (Social Security and Medicare) and other payroll taxes. Some owner-shareholders make the mistake of not paying themselves reasonable compensation, either out of unfamiliarity with the rules or to avoid payroll taxes.
The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee for federal employment tax purposes. S corporations should not try to avoid paying employment taxes by treating compensation as cash distributions, personal expenses, or loans rather than wages.
If the S Corporation doesn’t pay the working shareholders reasonable compensation, the IRS can treat a portion of the S Corporation’s distributions as wages and impose Social Security taxes on those deemed wages.
Determining Reasonable Compensation in an S Corporation
There’s no specific method for determining what constitutes reasonable compensation—it’s based on facts and circumstances. Generally, it’s an amount that unrelated employers would pay for similar services under like circumstances and considering the cost of living in the area where the business is located.
Here are some factors considered when determining reasonable compensation:
- âś… Training and experience
- âś… Duties and responsibilities
- âś… Time and effort devoted to the business
- âś… Dividend history
- âś… Payments to non-shareholder employees
- âś… Timing and manner of paying bonuses to key people
- âś… Comparable businesses’ pay for similar services
- âś… Compensation agreements
- âś… Formulas used to determine compensation
The problem is that it’s easy for the IRS to list these contributing factors and leave it to the corporation to quantify them into a reasonable salary. However, they can still challenge the amount if an auditor decides the compensation is unreasonable.
The IRS has a long history of examining S Corporation tax returns to ensure reasonable compensation is being paid, especially if no compensation is shown as paid to employee-shareholders.
Reasonable Compensation in the Spotlight đź’µ
With recent tax reforms, reasonable compensation is crucial due to the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will be included on the shareholder’s income tax return. The QBI for the shareholder of an S Corporation is the amount of net income passed through to the shareholder and designated as QBI on the K-1. However, the shareholder may not include the reasonable compensation (wages) they were paid as QBI. Thus, wages paid to shareholders reduce the QBI because the S Corporation deducts the wages as a business expense, reducing the corporation’s net income and QBI. But wages cannot be arbitrarily adjusted to maximize the Sec. 199A deduction.
IRC Sec. 199A Deduction
Here are some details about how the 199A deduction works and the impact of reasonable compensation wages on the Sec. 199A deduction:
- đź’ˇ The S Corporation’s employee-shareholders’ wages are NOT included in QBI when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and, therefore, the smaller the 199A deduction, which is 20% of QBI. An S Corporation may pay the shareholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
- đź’ˇIf married taxpayers filing a joint return have taxable income exceeding $315,000 ($157,500 for other filing statuses), the 199A deduction begins to be subject to a wage limitation. Once the taxable income for married taxpayers filing a joint return exceeds $415,000 ($207,500 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. For these high-income taxpayers, an S Corporation may pay shareholders less wage income for them to benefit from the Sec. 199A deduction.
- 💡If an S Corporation is a specified service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between \$315,000 and \$415,000 (between \$157,500 and \$207,500 for other filing statuses). Although the wage limitation is used in computing the phase-out, once the taxpayer’s taxable income exceeds \$415,000 (\$207,500 for other filing statuses), the taxpayer will receive no benefit from the wage limitation and would again want to minimize their reasonable compensation to reduce FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services.
Determining Reasonable Compensation đź“‘
Taxpayers cannot simply pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for those who do not consider the factors related to reasonable compensation. Commercial firms have the data necessary to determine reasonable compensation and specialize in doing so. These firms can be found by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.
Need Help Setting Reasonable Compensation in Your S Corp?
If you need additional information related to reasonable compensation, don’t hesitate to call us. We’re here to ensure your S Corporation stays compliant and tax-efficient. Contact us today to discuss how we can help your business thrive in 2024 and beyond.