1. Reasonable Compensation – Generally, an officer of a corporation is an employee of the corporation. That an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officers/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes. The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.
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. The following are 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
- Use of a formula to determine compensation
The IRS has the authority to re-characterize distributions to officers/shareholders who do not receive adequate compensation for services rendered. Re-characterized distributions are treated as taxable wages, and the IRS will assess employment taxes on these deemed wages.
2. Health Benefits Paid for a 2% Shareholder – The health and accident insurance premiums paid on behalf of a greater than 2% S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security, Medicare or, in most states, Unemployment taxes. Therefore, this additional compensation should be included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2. Be sure to clearly identify this amount on the Form W-2 for the shareholder as the cost of these benefits will be included in income by the employee-shareholder on their Form 1040 with an offsetting adjustment to gross income on the bottom of page one of their Form 1040.
If a shareholder-employee directly pays the premiums for an individual policy (including Medicare premiums) and is reimbursed by the company during the year, the reimbursement would also need to be reported as outlined above. Failure to include these benefits on Form W-2 will result in full taxation of the benefits and a disallowance of the deduction for these benefits. Related party rules may also apply to some family members/related parties who are employees of the company even if they do not have any (or less than 2%) ownership of the company. Contact us if you require any assistance in performing this calculation or have any questions on how to record this benefit on the Form W-2.
3. Distributions – Remember that cash and/or property distributions to S Corporation shareholders must be proportionate to the shareholders’ respective stock ownership. Failure to observe this rule could potentially result in the revocation of the Corporation’s S election. Also, distributions of depreciated and/or appreciated property may result in a taxable event.
4. Expenses Paid by Shareholders – In general, for expenses to be deductible by a cash-basis S Corporation, all expenses should be recorded on the books of the corporation and be paid by the corporation. All business related expenses paid or incurred by shareholders (including mileage, cell phone, meals, etc.) should be submitted to and reimbursed by the corporation during the calendar year in which they are incurred. In so doing, the deduction is preserved at the corporate level and the reimbursement is not included in the shareholder’s income. An employee/shareholder may deduct certain unreimbursed reasonable employee business expenses as a miscellaneous itemized deduction on Schedule A, but that deduction is subject to a floor of 2% of adjusted gross income and is not deductible in computing alternative minimum tax. A much better result is achieved by having the employee/shareholder be reimbursed by the corporation for employee business expenses. Further, a shareholder may not directly offset his business income on Schedule E with these expenses. They must be reported on Schedule A and are subject to limitations.
Should you have any questions on the above reporting requirements or want to know more about tax planning ideas, please do not hesitate to contact your Elliott Davis advisor, or you can reach us at firstname.lastname@example.org.