Over the past several years, the IRS has increased its scrutiny of S Corporations in light of reasonable compensation.
When you do business as a sole proprietorship or as a partnership, the profit that flows out to your individual tax return is subject not just to income tax but to self-employment tax as well. The self-employment tax rate is 15.3% and funds your Social Security and Medicare accounts and that substantially increases your tax liability. When you incorporate your business, making it a sub S Corporation, any profit that passes through to your individual income tax return is subject only to income taxes. You don’t need to pay self-employment tax on those proceeds.
As you can see, there is a significant financial benefit to incorporating your business. That said, I do not recommend that you incorporate unless you have discussed all of the ramifications with your attorney and your tax professional. It’s not as simple nor could it necessarily be as great an idea as it sounds.
So why is the IRS looking at S Corps? Many shareholders of these corporations believe they can take a small or no salary at all and let the entire profit pass through to their individual tax returns to create beaucoup savings.
However, the IRS code dictates that compensation must be reasonable and how the agency determines this depends upon facts and circumstances. If your business is suffering a hardship, you are likely to pay other bills and live off your own savings and you will have very little W2 earnings, a small profit or possibly a loss passing through to your individual income tax return. If this is the case, the IRS likely will not bother you. But let’s say business is booming. You’re an attorney but you show W2 wages of only $35,000 for the year and your share of the S Corporation profit is $350,000.Not only is the disparity between the two items of income a red flag, but the IRS wonders how any attorney would go to work for wages of only $35,000. After all, part of the reasonableness test is to compare your W2 take with that of industry standards in your area.
If you fail the tests, you can bet the IRS is going to re-categorize that income. In the case mentioned above, they will likely reverse the two numbers, making your wages at $350,000 and your distribution at $35,000. What’s more, on top of this will be a harsh levy of penalties and interest. It could also lead to a full blown audit of past tax returns. The auditor might wonder if you’re pulling a fast one somewhere else on your tax return.
By the same token, the IRS scrutinizes excessive compensation. This is something aimed more at publicly- held C Corporations. If officer compensation is in excess of $1 million per year for the three highest compensated officers, the IRS may want to take a look.
The IRS employs what is known as a “single independent-investor test” in evaluating if a stockholder-employee’s pay is reasonable. It essentially analyzes whether an outside investor would approve of the compensation paid. If its findings are not in the corporation’s favor, they may disallow the deduction of any amounts paid above $1 million.
If your corporation provides health, life, disability, or accident insurance make sure that you comply with the IRS’ nondiscrimination rules. Check with your tax pro to ensure that you are in compliance.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.