The S Corporation Conundrum

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

S corporations or small business corporations are a very smart tax move.  70% of 4.2 million tax returns filed last year were S corporations.  68% of those S corporation tax returns filed had problems.  The number one problem they had was a failure to adequately pay the owner/shareholder/employee/officer, yes we are all that rolled into one, an adequate salary.  In other words, we don’t pay social security taxes on the amount of money we draw out of the business.   

S corporations have long been a vehicle for shareholder-employees to escape social security and medicare tax because of a rule which allows a shareholder to earn a "return" on his investment in the company in addition to compensation for working in the company. While compensation is for work efforts and is taxable for social security and for medicare tax purposes, the "return" payment is for funds invested in the business and is not subject to social security or medicare taxes. Since social security and medicare taxes equal 15.3% of the payment, one can understand why all S corporation shareholder-employees want a majority of their payments to be classified as "return" rather than compensation.

More Art Than Science

When corporations elect subchapter S status, the IRS sends out a notice to shareholders reminding them that shareholder/employees must be paid reasonable salaries. The notice also states that the IRS can reclassify as salaries any distributions to the shareholders. This statement has been sent out since 2005, about the time the IRS determined that it needed to curb abuse of the reasonable-salary rule. Determining what a reasonable salary is maybe more art than science, but the attempt must be made.

Because the IRS’s goal is to collect Federal Insurance Contributions Act (FICA) tax on the salaries, one solution is to pay the maximum amount of wages subject to Old Age, Survivors and Disability Insurance (OASDI, or Social Security) tax, assuming of course this is a reasonable salary, based on the SE’s services actually rendered. The maximum salary subject to OASDI in 2017 is $127, 200. (All wages, without limit, are subject to the other component of FICA, Medicare tax.) This may be appropriate for a shareholder in a full-time executive role, such as CEO or controller, assuming similarly situated executives aren’t paid significantly more in competitive businesses.

A smaller salary may be justified for an executive in a startup or a relatively small corporation. That means us. The corporation could also examine comparable wages within its industry by consulting trade publications. The salary should also consider the stockholder’s experience and skill, the geographic region, customer base, number of employees and time committed to the corporation. What is a reasonable salary depends on the facts of each case. No test is conclusive. It often becomes a judgment call by the IRS.

Furthermore, the IRS has not published criteria to determine what is a reasonable salary or salary range that might be reasonable for various positions in a given industry. Comparable salaries from industry data are usually appropriate. Any tax preparer can use search engines on the Internet to find just about any type of salary in any industry for given regions.

In at least one instance, the Tax Court allowed statistical data from an industry and region to be used as guidance for reasonable compensation (Wiley L. Barron v. Commissioner, TC Summary Opinion 2001-10).

Barron, an Arkansas CPA, was the sole shareholder and CEO of an S corporation. In 1994, the S corporation paid him a salary of $2,000. No salary was paid in 1995 or 1996. He received cash distributions in 1994, 1995 and 1996 of $56,352, $53,257 and $83,341, respectively. The Tax Court accepted the analysis of an IRS consultant, who estimated that reasonable compensation for a CEO of an Arkansas CPA firm of similar size for those years was $45,000, $47,500 and $49,000.

Important stuff. I am required by IRS Circular 230 to warn you about, no let me change that to educate you fellow S corporation owner, that by not paying an adequate salary you are subjecting yourself to higher IRS scrutiny and possible very expensive penalties. I am now required to attach  form 1125 E which not only requires us to report your name, social security number, address, but also the compensation you paid yourself during the tax year. The IRS is in fact getting serious about this issue.

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

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages.  Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.  Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes.  S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

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, which was most recently updated in August 2012, the issue remains as clear as mud. It is extremely important not to overlook paying yourself a salary before the end of the year.  I don’t want to overlook the one important benefit of paying social security taxes….it is all refundable when you retire and increases your benefit.   

Again I want to remind you that 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.

By the way there has been 25 cases filed in Tax Court since 2008 concerning the reasonable compensation issue and the IRS has won every single one of them.

Sources:  AICPA, IRS.gov  and tax net.com

Charitable deductions are not just about giving money.

Here is information from IRS as something they call a "Summertime Tax Tip."


During the summer, some taxpayers may travel because of their involvement with a qualified charity. These traveling taxpayers may be able to lower their taxes.
Here are some tax tips for taxpayers to use when deducting charity-related travel expenses:

• Qualified Charities.  For a taxpayer to deduct costs, they must volunteer for a qualified charity. Most groups must apply to the IRS to become qualified. Churches and governments are generally qualified, and do not need to apply to the IRS. A taxpayer should ask the group about its status before they donate. Taxpayers can also use the Select Check tool on IRS.gov to check a group’s status.
• Out-of-Pocket Expenses.  A taxpayer may be able to deduct some of their costs including travel. These out-of-pocket expenses must be necessary while the taxpayer is away from home. All costs must be:
• Unreimbursed,
• Directly connected with the services,
• Expenses the taxpayer had only because of the services the taxpayer gave, and
• Not personal, living or family expenses.
• Genuine and Substantial Duty.  The charity work the taxpayer is involved with has to be real and substantial throughout the trip. The taxpayer can’t deduct expenses if they only have nominal duties or do not have any duties for significant parts of the trip.
• Value of Time or Service.  A taxpayer can’t deduct the value of their time or services that they give to charity. This includes income lost while the taxpayer serves as an unpaid volunteer for a qualified charity.
• Travel Expenses a Taxpayer Can Deduct.  The types of expenses a taxpayer may be able to deduct include:
• Air, rail and bus transportation,
• Car expenses,
• Lodging costs,
• Cost of meals, and
• Taxi or other transportation costs between the airport or station and their hotel.
• Travel Expenses a Taxpayer Can’t Deduct. Some types of travel do not qualify for a tax deduction. For example, a taxpayer can’t deduct their costs if a significant part of the trip involves recreation or vacation.

For more on these rules, see Publication 526, Charitable Contributions. Get it on IRS.gov/forms at any time.

Want to get angry? Read this Forbes article about Illinois' courts are bankrupting the state by awarding workers compentation awards.

"The commission handling workers’ claims and the courts that supervise it have endlessly expanded the liability of employers, forgetting that the system was supposed to cover only employment-related injuries. One Illinois court held, for example, that a worker was entitled to benefits when he was injured throwing himself up against a vending machine in an attempt to dislodge a stubborn bag of potato chips. The court said that the injured employee was a deserving “Good Samaritan” on a rescue mission to help a fellow co-worker who had deposited the coins. The court thought that the defect in the vending machine “created a need for action to dislodge the bag of Fritos.” (I am not making this up!)


Illinois’ bottomless workers’ compensation system has contributed to the state ranking as one of the most labor-expensive states. In the construction industry, for example, $20 of every $100 of wages goes to workers’ compensation (in neighboring Indiana it’s less than $5). It is perhaps one more reason why the state has lost 300,000 manufacturing jobs since 2000, and why, unlike its Midwest neighbors, it has not enjoyed any manufacturing job growth since the Great Recession.

In the public sector, the effect is even grimmer. State workers file workers’ compensation claims far more often than in any other employment sector, costing more than 4 percent of government payroll. A whopping one third of Illinois state employees have open claims alleging work-related injuries. (Is it really that dangerous to work for the state?) The claimants are often counseled by lawyers, whereas poor Illinois does not have the resources to either defend this Tsunami of claims or pay the insurance premiums.

It is not obvious why the Illinois workers’ compensation system unraveled, but let’s see who benefits from this cash cow. As in any litigation-intensive area, lawyers do well. The paradigm of a litigation-free insurance system is long dead in Illinois, where 52 percent of workers’ compensation claimants—more than in any other state—are represented by an attorney. (In neighboring Wisconsin only 13 percent are represented.) Health care providers also benefit, since the fees for work injury medical treatments are much higher than the fees Medicare pays for the same treatments. But a big part of the blame is on judges. Don't courts realize that dealing out insurance benefits makes premiums more expensive? That such reckless courtroom generosity would drive employers out, and the state’s finances to the ground?"



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