There have been a number of rumors spread among the accounting community lately that the IRS has eliminated the ability for professionals who operate their business as an S Corporation to receive distributions from their companies in lieu of a wage or salary. On May 28th, 2010, The House passed The American Jobs and Closing Tax Loopholes Act of 2010 which contains a provision that proposes to raise over $11 billion by tacking on payroll taxes to certain service professionals who currently split income as wages and draws. And by certain service professionals, Congress specifically means those in “health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services. If this change becomes law, it can add a 15.3% surcharge to the distribution portion of the income that S Corporation owners pay themselves. The Senate has taken this issue up in its June session.
S Corporations are entities where the net income from the corporation passes to the shareholders and gets taxed at the shareholders marginal rate of taxation. S Corporation owners typically receive income from their businesses in two forms:
1) A salary or wage and
2) A distribution.
The salary/wage income component is subject to social security, medicare and unemployment taxes. The distribution component, however, is not subject to these payroll taxes, which in many cases allows the business owner to avoid 15 percent or more in payroll taxes. Here lies the problem.
The wants the payroll tax dollars associated with a salary and the professional wants to maximize the distribution portion of their income from the S Corporation in order to save payroll tax dollars. Although used widely in tax planning, this strategy has recently been dubbed the “John Edwards loophole” because the former presidential contender used it to pay himself millions from his S corporation. Edwards paid himself a $360,000 salary from his S corporation, but then took an additional $26 million from the firm that was subject to income taxes, but not employment taxes. The loophole which is completely legal likely saved Edwards at least $500,000 in taxes.
So what should professionals do today who are potentially affected by this change? At this point it’s a wait and see issue on the legislation. S Corporation owners must, however, take immediate steps to get in compliance with the existing laws relative to the compensation they receive from their businesses. The IRS requires S Corporation owners to pay themselves a reasonable salary from their business. Unfortunately, there is no clear standard from the IRS that the business owner can rely upon to make this determination. The IRS does offer some guidance in its audit manual that covers this issue and they have listed the following factors the auditor should evaluate when determining the reasonableness of an employee’s compensation:
1. Nature of the employee’s duties.
2. The employee’s background and experience.
3. The employee’s knowledge of the business.
4. The size of the business.
5. The employee’s contribution to the profit making of the business.
6. The time contributed by the employee to the business.
7. The economic conditions in general and locally.
8. The character and amount of responsibility of the employee.
9. The time of year when compensation is determined.
10. The relationship of the shareholder/officer’s compensation to stock holdings. Politics
11. The amount paid by similar businesses in similar areas to equally qualified employees for similar services.
You may be asking why it’s so important to address this compensation issue today beyond the recent House legislation that just passed. The reason is that the IRS has identified this issue as a key area for increased enforcement which translates into higher chances of audit. The Service has upgraded its computer selection methodology where it can electronically compare the amount of officer compensation reported on the tax return with the amount of distributions that the shareholder receives. Professionals with S Corporations that pay themselves a nominal salary are going to get selected for audit. Moreover, the IRS in March of this year began a three year employment tax audit program where 6,000 businesses are going to be randomly selected for audit specifically targeting employment tax issues. We have not seen these types of audits in nearly 20 years. Reasonable compensation issues have been publicly identified as one of the key areas of audit emphasis by the Service in this program. And finally, there are several tax court cases matriculating through the system where the IRS is attempting to re-characterize distributions as wage compensation. So far, they have been successful in these legal efforts.
Due to the increased emphasis on employment tax issues by the Service, businesses must take the following immediate steps to ensure their compensation formulas are in compliance:
1. Document the compensation plan in your corporate records. S Corporations should hold a board meeting at the beginning of the year with resolutions prepared that approve the compensation plan for the officers.