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Compensation issues for S corporations: compensation or distributions?

The Revenue Reconciliation Act of 1993 (RRA '93) repealed the dollar limit on earned income and self-employment income subject to the Medicare hospital insurance tax. After 1993, all compensation and self-employment income is subject to the tax. This places a new perspective on the issue of compensation versus distributions for S corporations.


The primary motivation for the election of S corporation status has been the avoidance of the corporate level tax. In addition, use of the S corporation status avoids the accumulated earnings tax, the personal holding company tax, and many troublesome personal service corporation sections.

Use of an S corporation also tended to reduce the problems associated with unreasonable compensation. If the earnings of the S corporation were taxed as salary to the officer shareholder, they were not taxed as a distribution. The IRS obtained its "fair share" in either case. The question of inadequate compensation may have been raised for an S corporation in situations where salaries were being paid to several family members - some of whom were in lower tax brackets - with the effect that a disproportionately low salary was being paid to those contributing most to the profitability of the S corporation.

The change in the Medicare tax limit has increased the significance of the adequacy of compensation paid to stockholder/employees of S corporations. Compensation received by stockholder/employees is subject to employment taxes. The shareholder's distributive share of the corporation's income, whether distributed or not, is not subject to these taxes. Consequently, this change in the Medicare tax creates an additional motive for the IRS to claim that compensation is unreasonably low and to attempt to recharacterize distributions or undistributed income as compensation. The total Medicare rate is 2.9%. The full amount is payable on what is considered self-employment income. The employer and the employee are each subject to a 1.45% tax if the income is considered compensation for services.

A taxpayer receiving compensation in the amount of $250,000 in 1994 or later will pay $1,667 more in Medicare hospital insurance than in 1993. This increase is doubled when the employer's portion of the tax is added to the employee's portion.

Noncompensation Earnings From an S Corporation Are Not Self-Employment Income

IRC Sec. 1402 defines "net earnings from self-employment" as "the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business..." This definition is very close to the actual calculation in arriving at net income to be reported to the S corporation shareholder.

Under Reg. Sec. 1.1402(c)-1, the term "trade or business" for the purpose of the tax on self-employment income has the same meaning as when used in IRC Sec. 162. IRC Sec. 162 allows for the deduction of trade or business deductions in determining the taxable income of a C corporation as well as an S corporation.

Per Rev. Rul. 59-221, earnings of S corporations which were required to be included in each shareholder's gross income were not "self-employment income" to the shareholders. The rifling indicates that the undistributed taxable income of an S corporation that must be included in a shareholder's income is not income from a trade or business. It states that neither the election by a corporation as to the manner in which it will be taxed nor the consent to the election by the corporation's shareholders causes the consenting shareholders to be treated as being engaged in carrying on the corporation's trade or business. Although this revenue ruling was issued under pre-1983 law, it has not been superseded.

If the payment of the shareholders' distributive shares of earnings based on their respective stock ownership were defined as dividends, these distributions would still be excluded from self-employment income. IRC Sec. 1402 excludes dividends from the calculation of net earnings from self-employment income, except when they are received in the course of a trade or business as a dealer in stocks or securities.

Inadequate Compensation Treated as Unreasonable

An alternative is to recharacterize earnings distributions from an S corporation as disguised payments of compensation to the shareholders. In Rev. Rul. 74-44 the "dividends" paid to two shareholders were held to be in lieu of reasonable compensation for their services. The shareholders drew no salary from the corporation but arranged for the corporation to pay them "dividends," which happened to be the exact amount due them for the services rendered to the corporation. The ruling states that such compensation represented "wages," and liability was incurred for FICA withholding, Federal unemployment taxes and withholding of Federal income taxes. In the example discussed in the ruling, the intent to avoid payment of employment tax was apparent. The intent was to compensate the shareholders for services, and the amounts received were reclassified as wages.

The issue of inadequate compensation has been litigated. In Joseph Radke, 712 F. Supp. 143 (E.D. Wis. 1989), aff'd per curiam, 895 F.2nd 1196 (7th Cir. 1990), the court upheld the IRS's assessment of payroll taxes on the taxpayer's deemed salary. In Radke, the sole shareholder/employee was an attorney who incorporated his practice and continued to take monies out on an as needed basis when the corporation had cash. The court held that not all corporate income may be reclassified as wages, but that payments made for remuneration of services performed clearly fell within the statutory and regulatory definition of wages. The Seventh Circuit determined that regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments are for remuneration for services rendered.

Sympathy May Not Exist

An amount must have been so intended and treated as compensation at the time of the payment to be considered reasonable compensation and deductible by the corporation. In Paula Construction Company [58 TC 1055, 1058 (1972), aff'd by unpub. op. 474 F 2d 1345 (5th Cir. 1973)], the Tax Court stated the standard as follows: "It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case." In Paula, the taxpayer was an S corporation whose election was retroactively terminated. The principal shareholders-employees never made provision for compensation in the corporate books or tax return in the apparent belief that the corporation's S status made it unnecessary to claim salaries. The Tax Court acknowledged that the two shareholders performed substantial services for the corporation for which they were entitled to receive compensation. However, since the intent was not to pay compensation, no compensation was deductible. It would seem that a double standard is being applied here. If the S election had not been terminated, the IRS would have been motivated to recharacterize the payments as compensation.



1. The nature of the services performed

2. The responsibilities involved

3. The time spent

4. The size and complexity of the business

5. Prevailing economic conditions

6. Compensation paid by comparable firms for comparable services

7. Salary paid to company officers in prior years

Cases Involving Social Security Benefits

In some cases, the Social Security Administration has had success in recharacterizing S corporation distributions as wages for purposes of determining excess earnings for recipients of Social Security benefits. In both Owens [Charles B. Owens, Jr., 790 F. Supp. 195 (W.D. Ark. 1991) and Esser [Fred R. Esser, 750 F. Supp. 421 (Ariz. 1990)], reportedly retired individuals continued to perform considerable services for their S corporations. These individuals reported no compensation income, leaving the income to be reported as their distributive share of S corporation income. The courts required that the distributions be treated as compensation. This treatment required a reduction in the amount of Social Security benefits allowed to the taxpayers. The facts in the Radke case were cited in both of these cases.

Corporate Officers

A corporate officer is generally considered to be an employee of the corporation for purposes of Federal employment tax. Per Rev. Rul. 73-361, a majority shareholder, who was also an officer of an S corporation, performed substantial services for the corporation for which he received a salary, and was considered to be an employee. The fact that the corporation had elected S status had no bearing on whether or not the stockholder-executive was an employee. As an employee of the corporation, the shareholder/officer was subject to Federal unemployment taxes, FICA, and income tax withholding requirements.

Planning Opportunities

The issue now appears to be more one of adequate compensation vs. inadequate compensation. A return matching program has been implemented by the IRS to compare employment tax forms with information returns filed by S corporations to determine whether salaries have been paid by the S corporations and whether FICA and other payroll taxes have been properly calculated and paid. The determination of the adequacy of the compensation will obviously take more time and effort than computing a matching program. A facts-and-circumstances approach would appear to be the only way to evaluate the individual salary cases.

As in any area of tax law that will be determined on a facts-and-circumstances basis, taxpayers should take great care to document justification for their level of compensation. Each of the factors in the accompanying table should be evaluated and their applicability documented.

If the IRS does determine that the shareholders actually received wages instead of dividends, the corporation may be subject to substantial underpayment of payroll tax. The corporation should have been withholding FICA as well as regular Federal and state income tax and making deposits of those withholdings along with employer's share of the FICA tax. Those wages would also be subject to Federal unemployment tax and any applicable state unemployment tax.

Patricia S. Gates, CPA, is a practicing CPA in Tulsa Oklahoma. Darlene A. Smith, PhD, CPA, is an associate professor of accounting at the University of Tulsa.
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Title Annotation:Federal Taxation
Author:Gates, Patricia S.; Smith, Darlene A.
Publication:The CPA Journal
Date:Nov 1, 1995
Previous Article:Business risk, internal control, and audit implications of EDI.
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