Unlike a C corporation, which pays taxes on its income, an S corporation distributes its income, losses, deductions, and credits to shareholders’ individual tax returns on a pro-rata basis. These distributions aren’t subject to self-employment (Social Security and Medicare) taxes.

The Need for Reasonable Compensation

Many S corporations overlook the requirement that each shareholder-employee must take reasonable compensation as W-2 wages for services performed. These wages are subject to Social Security and Medicare taxes (split between the corporation and the employee) and the Federal Unemployment Tax (and possibly state unemployment taxes).

Distinguishing Roles: Shareholder, Officer, Employee

The Internal Revenue Code states that an officer of an S corporation is considered an employee for Federal Unemployment Tax purposes. S corporations should not attempt to avoid this tax by treating officers’ compensation as distributions rather than wages.

Unreasonable Salaries and Employment Taxes

This issue has persisted for decades. In 1974, the IRS ruled that if a shareholder-employee doesn’t take a salary, or if it’s unreasonable, an auditor can reclassify distributions to account for reasonable compensation, assessing the related employment taxes and penalties. This includes the employee’s 6.2% Social Security and 1.45% Medicare payroll taxes, the S corporation’s matching amounts, and the Federal Unemployment Tax.

Who Is an Employee?

An officer of a corporation is generally considered an employee. Being a shareholder doesn’t change the requirement that any payments to an officer must be treated as wages. Courts have consistently ruled that S corporation shareholders who provide more than minor services to their corporation are employees whose compensation is subject to federal taxes. There’s an exception for officers who do not perform or perform only minor services.

What’s a Reasonable Salary?

According to Form 1120S instructions: “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.” There are no specific guidelines in the tax code for reasonable compensation. Courts base their decisions on the facts and circumstances of each case.

IRS Factors for Determining Reasonable Compensation

Factors considered by courts and the IRS when determining reasonable compensation include:

👉 The officer’s training and experience
👉 The officer’s duties and responsibilities
👉 The time and effort devoted to the business
👉 The corporation’s dividend history
👉 Payments to non-shareholder employees
👉 Timing and manner of bonuses paid to key people
👉 Payments by comparable businesses for similar services
👉 The corporation’s compensation agreements
👉 Compensation formulas used by similar corporations

IRS Oversight and Challenges

The IRS often examines S corporations’ tax returns to ensure reasonable compensation is paid, especially when no compensation is paid to employee-stockholders.

The Pitfalls of Maximizing Deductions

Taxpayers can’t choose a compensation level to minimize taxes or maximize deductions without considering all factors related to reasonable compensation. Gathering the necessary data to support this can be complex and time-consuming. Some commercial firms have the resources to apply these factors properly, providing backup in case of an IRS challenge.

Get Expert Help with Employee Compensation for Your S Corp

Determining shareholder compensation can be tricky for S corporations. If you have questions about reasonable compensation for S corporation shareholders or its impact on your specific tax situation, call the experts at Insogna CPA. We’re here to help you navigate these complexities and ensure compliance.

If you need personalized advice or have specific questions, don’t hesitate to reach out to Insogna CPA. Let’s make sure your S corporation is in top shape for 2024!

In the world of business, transactions can get complicated, and it’s essential to keep everything above board to avoid trouble with the IRS.

Today, we’re diving into a vital aspect of corporate finances: loan documentations within your corporation.

The Loan Dilemma: C vs. S Corporations

Whether you’re lending money to your corporation or receiving loans from it, proper documentation is key. Failure to do so can lead to unexpected tax consequences that no one wants to deal with. Let’s break down the potential pitfalls:

💡 S Corporation Woes: If you’re operating as an S corporation (scorp), any loan that isn’t correctly documented can result in taxable wages for you. Ouch!

💡 C Corporation Conundrum: For those of you in C corporations (ccorp), an undocumented loan can lead to taxable dividends being issued to the shareholder. Not a pleasant surprise.

The Teymourian Story: A Cautionary Tale ⚠️

Let me share the story of Nariman Teymourian, who went through a nerve-wracking IRS audit. At the end of it all, the IRS claimed he owed over \$600,000 in taxes and penalties, mainly due to advances he received from his majority-controlled corporation.

The good news? Mr. Teymourian triumphed in court and paid zero additional taxes. The bad news? He had to go to court in the first place. Let’s learn from his experience and avoid similar pitfalls.

The Importance of Good Record-Keeping

When you operate as a C or S corporation, meticulous paperwork is your best friend. The IRS will closely scrutinize your advance accounts and make one of two determinations:

👉 Advances as Loans: The advances are recognized as loans from the corporation to you.

👉 Advances as Dividends (C-Corp only): The advances are considered disguised dividends, subject to taxation.

Clearly, there’s a massive difference between a loan and a taxable dividend. To ensure you’re on the right side of the IRS, let’s dive into a checklist inspired by Mr. Teymourian’s story.

Your Loan Documentation To-Do List

To avoid tax headaches, make sure you can answer “yes” to these seven crucial questions:

1️⃣ Promissory Note: Did you sign a promissory note or another document promising to repay the money to the corporation?
2️⃣ Interest Payments: Did you pay interest on the advances?
3️⃣Scheduled Payments: Did you make payments on a fixed schedule, such as monthly or quarterly?
4️⃣ Collateral: Did you provide collateral to secure your repayment?
5️⃣ Repayment: Did you physically repay the loan?
6️⃣ Credit Checks: Did the corporation assess your ability to repay by checking credit reports and statements of net worth?
7️⃣ Loan Behavior: Did both you and the corporation treat the advances as loans in your actions and paperwork?

Remember, you may be asked these questions years down the line, so ensuring “yes” answers from the start is crucial. The more “yes” answers you have, the safer your financial position.

🛡️Protect Your Business and Your Wallet

Operating as a C or S Corporation comes with numerous benefits, but it also requires diligence when it comes to documentation. Don’t wait until the IRS comes knocking at your door. Follow these guidelines and protect your business from unnecessary tax burdens.

If you have questions or need assistance with your corporation’s financial documentation, our experienced team at Insogna CPA is here to help.

Let’s ensure your business stays in the clear when it comes to loans and taxes. Don’t wait until it’s too late – safeguard your financial future now!

Business CPA