S corporation owners, the IRS, and the importance of paying yourself a salary subject to social security tax.

Being licensed by the IRS does come with some important responsibilities.  Accordingly I am fulfilling my Circular 230 responsibility by writing to all clients who operate their business as S Corporations reminding you of the importance of paying social security tax

As an S Corporation owner you are not alone. S Corporations are the single most popular form of corporate entity in the United States.  This year more than 70% of the 4.1 million tax returns filed in the United States will be S Corporation returns.  68% of those 4.1 million tax returns had problems.  

As a quick refresher, an S Corporation is not subject to corporate tax rates. "Generally, an S Corporation is exempt from federal income tax other than tax on certain capital gains and passive income," according to the Internal Revenue Service.  Instead, an S Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation's profits are only taxed once– at the shareholder level. The IRS explains it this way: "On their tax returns, the S Corporation's shareholders include their share of the corporation's separately stated items of income.

S Corporations therefore avoid the so-called "double taxation" of dividends.  S Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as-if they were distributed to shareholders. Thus an S Corporation shareholder might be taxed on income they never received. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)

The big benefit--and the one that people usually talk about--is the payroll tax savings.

To understand how this works, let me compare two alternatives: A sole proprietor making $90,000 a year and an S Corporation making $90,000 a year.

Of course, the taxes that a sole proprietor pays depends on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes.

In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social security and Medicare tax) equals $13,000.

Things usually work differently for the S corporation, however. To make calculations easy, assume the S corporation is owned by a single shareholder. In this case, the S corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000.

In this case, even though the two businesses make the exact same amount of money, the S corporation pays roughly $7,000 less in tax each year.

So what is the problem that the majority of S Corporations filed this year?

For the first time the IRS has concluded its National Research Program (NRP) specifically looking at employers. The goal of National Research Program is to design and implement a successful strategy to collect data that will be used to measure payment, filing and reporting compliance.  Results are based on examinations of 50,000 employers (also known as the audit from hell) in order to statistically do a better job determining which returns would produce the greater compliance.  The results are in. Issues IRS will focus on for determining which taxpayers to audit include the 1120 S, Small Business Corporation salaries paid to stockholder/officers .

The advantage of paying yourself a salary.

• Social security tax is refundable.  It adds to your benefits.  The more you receive the more you will receive in benefits when you retire.
• Paying yourself increases tax deductions. Many times it will more than exceed the initial cost of paying the tax.  IRA, SEP, and self employed health insurance deductions are all dependent on the salary of the S Corporation

The number one IRS audit risk for S Corporations is salary and wages paid to officers of the corporation.

Here is what the IRS says about wages and salary paid to officers of Subchapter S Corporations:

What's a Reasonable Salary?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "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."

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.  However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Some factors considered by the courts in determining reasonable compensation:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

Although this IRS interpretation of reasonable salary was updated in October 2012,  it is somewhat arbitrary, it is extremely important not to overlook paying yourself a salary before the end of the year.  Determing salary is more art than science.  There is no set formula.  

The IRS can collect payroll taxes on officer compensation, and the penalty for failing to pay payroll taxes is 100% of the taxes owed. S-Corporations will avoid this payroll tax penalty by paying shareholder-employees a reasonable compensation.

What should you do? Don’t panic. Call us.  We can help. There is still time to fix any oversights.

Remember what Ben Franklin said an ounce of prevention is worth a pound of cure.  He also said that there are only two certain things in life:  death and taxes.

The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.