Tax File Memo

Reasonable S-Corporation Wage

Facts

The taxpayer is a medical professional engaging independently in profit-generating activities within his S-corporation.  The S-corporation does not employ any other individuals, and all cash inflows are related to his activities.

Issues

What constitutes a reasonable wage?

Conclusion

The taxpayer will report all cash distributions to himself as wages for services performed.

Analysis

According to IRS FS-2008-25, 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.

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.

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.

  • 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

In Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. No. 14 (2001) aff’d without published opinion, No. 02-1214 (3rd Cir. Dec. 18, 2002), the S corporation’s sole shareholder and officer provided all services on behalf of the S corporation and generated all of the S corporation’s income through services that he provided. The corporation did not pay the shareholder a salary; rather, the corporation distributed its net income to the shareholder, who then reported the payments (as indicated on the Schedules K-1) as nonpassive income from the S corporation. Consequently, the S corporation did not pay any FICA (social security and Medicare) or FUTA (unemployment) taxes under §§ 3111 and 3301 of the Internal Revenue Code. The court stated that §§ 3121(a) and 3306(b) generally define “wages,” for federal employment tax purposes, as all remuneration for employment. Pursuant to §§ 31.3121(a)-1(b) and 31.3306(b)-1(b) of the Employment Tax Regulations, the form of the payment is immaterial. Under § 3121(d), the term “employee” includes an officer of a corporation. Section 31.3121(d)-(1)(b) provides an exception for officers who do not provide any services (or provide only minor services) and who neither receive nor are entitled to receive remuneration. The court therefore held that “an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes.” Id. at 7. The court also stated that “an employer cannot avoid Federal employment taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation’s net income, rather than wages.” Id. at 8. Accordingly, the S corporation’s payments to the shareholder were recharacterized as wages. See also, Spicer Accounting, Inc. v. United States, 918 F.2d 90 (9th Cir. 1990).

IRS INFO 2003-0026 states that if a shareholder of an S corporation performs services for the corporation, any distribution to the shareholder, even if legally declared under state law by the S corporation as a dividend, will be characterized as “wages” subject to employment taxes where in reality the payments are for services. An S corporation cannot avoid employment taxes merely by paying the corporate shareholder “dividends” in lieu of reasonable compensation for services performed.