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S shareholders: compensation vs. distributions.

When the shareholders of an S corporation are also employed by the corporation, a question may arise whether amounts distributed by the corporation are compensation to the employee for services or distributions to the shareholder. This question normally arises when dealing with closely held corporations that have few, if any, employees other than those receiving the distributions.

CHARACTERIZATION

While it would seem the classification of these amounts should not make too much difference (since the S corporation is a passthrough entity and generally pays no taxes itself), in numerous situations the characterization of amounts distributed to an employee--shareholder can affect the tax results.

State taxation. If a state does not recognize S corporation status, all corporations are treated as C corporations. As such, the payment of compensation will reduce the corporation's income, thus lowering its state tax liability.

Retirement plan contributions. Contributions to qualified employee retirement plans usually are based on compensation paid. Therefore, categorizing amounts as compensation will allow such contributions to be made. (At the same time, increasing the amount of compensation will allow for larger contributions.)

Character of withdrawals. Amounts distributed as compensation will be trade or business income to a shareholder--employee, while income or loss passed through the corporation retains its original character (for example, the corporation's passive income will remain passive income to the shareholder and will be subject to the passive activity loss rules).

Pro rata payouts. Distributions must be made generally on a pro rata basis, while compensation need not be paid in proportion to shareholdings.

Note: Recharacterization of compensation could result in the corporation being treated as having made disproportionate distributions, resulting in a second class of stock that would make the corporation ineligible for S corporation status.

Payroll taxes. Amounts considered compensation will be subject to employment and Social Security taxes, which would be collected by the corporation.

Corporation's tax year. If the corporation has a fiscal year, compensation payment may effectively accelerate income to shareholders.

Social Security benefits. A taxpayer's Social Security benefits are subject to reduction if his or her earned income exceeds certain amounts. Compensation (but not distributions) is considered earned income for purposes of this determination.

CLASSIFICATION FACTORS

Some factors to be considered in determining the status of amounts distributed to shareholder--employees include the following.

For compensation. Did the employee receive any compensation in the form of salary? Were the amounts received reasonable compensation for services rendered? The key to determining compensation is reasonableness. If these amounts are considered excessive, the Internal Revenue Service may reallocate a portion as a distribution. Likewise, if an employee has received too little, the IRS may reclassify a distribution as compensation.

How much time was spent on the corporation's business? Were the services performed by the employee substantial?

Was the distribute the sole employee, director or officer?

For distribution. Were the services performed minor or nominal? Were there other outside directors (that is, any not working as employees)?

Should the shareholder have received some amount as a reasonable rate of return on the investment? Should the amount received by the employee--shareholder be separated, with only a portion of the distribution classified as salary? (Again, this goes to the concept of reasonableness.)

For a discussion of the recent cases in this area, as well as other recent developments, see the Tax Clinic department, edited by Gary Zwick and Alan Witt, in the August 1990 issue of The Tax Adviser.
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Author:Fiore, Nicholas J.
Publication:Journal of Accountancy
Date:Aug 1, 1990
Words:567
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