S Corps and Reasonable Compensation
For most of the country, the March 15th S Corp filing deadline has passed. However, for the storm-ravaged states of California, Alabama, and Georgia, the Internal Revenue Service (IRS) has extended the date to file various federal individual and business returns and make tax payments to October 16th, 2023. The October 16th deadline also applies to 2023 estimated tax payments, typically due on April 18th, June 15th, and September 15th. It also applies to the quarterly payroll and excise tax returns, usually due on January 31st, April 30th, and July 31st.
If you don’t live in one of those states and missed the deadline to claim the S Corp election, you can still file IRS Form 2553. However, your S Corp status will not begin until the following calendar year.
What is an S Corp?
An S Corp is a special tax election for limited liability companies (LLCs) and corporations made through the IRS. S Corps pass the company’s income, losses, deductions, and credits to their shareholders for tax purposes. And S Corp shareholders report the flow-through of income and losses on their individual tax returns, which allows S Corps to avoid double taxation on corporate income.
The S Corp election also helps LLC and corporation owners save on payroll taxes by allowing shareholders to divide business income into salaries and shareholder distributions. Because payroll taxes are only enacted on wages and not shareholder distributions, S Corp owners save money on taxes and can leave more profits in the business.
Unfortunately, because some business owners underpay their wages to save on payroll taxes, the IRS keeps a close watch on S Corps’ tax returns and dividend distributions. To keep companies honest, the IRS applies “reasonable compensation” guidelines to help your company stay out of hot water.
What is Reasonable Compensation?
To deter business owners from undercutting wages to avoid payroll taxes, the IRS mandates that S Corp owners be paid reasonable compensation for any services applied to the business operation. The IRS definition of reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Shareholders/owners doing anything more than only investing money in the company must be considered employees and paid salaries equal to those paid for services in comparable industries.
The IRS suggests business owners consider the following characteristics when determining a reasonable wage:
- What are the duties being performed?
- What volume of business is being handled?
- What are the characteristics of the job and the amount of responsibility attributed to the worker?
- Are there specific skills required or complexities of the position?
- How much time is necessary to do the job?
- What is the cost of living in the company’s location?
- Does the worker have special education to perform the position?
- How does the wage compare to the business’s gross and net incomes?
- What is the company’s policy regarding wages and wage increases?
- What is the salary history of each employee?
The IRS analyzes the S Corp’s gross receipts to determine the reasonableness and then establishes what tasks the owner/shareholder performed to help generate the company’s gross income. If owners aren’t sure about the salaries for specific positions, the U.S. Bureau of Labor Statistics has national wage data searchable by occupation, state, region, and city.
Even minimal services done for the company must be paid for, and therefore payroll taxes must be applied. Payroll taxes are determined by FICA (Federal Insurance Contributions Act), and all U.S. taxpayers must contribute to FICA taxes, which are Social Security and Medicare. The current social security tax is 6.2% of gross income, and employers and employees each contribute 6.2% to the Social Security fund. The Medicare tax is 1.45% of gross income; again, employers and employees contribute to Medicare. In addition, employers must pay a State Unemployment Insurance tax (SUI) in each state where the employee conducts business. SUI rates vary by state.
Can My Company File for the S Corp Election?
Companies structured as a C Corp or LLC can file for the S Corp tax election if:
- The company is a domestic corporation
- Shareholders are U.S. citizens or resident aliens
- The company has no more than 100 shareholders
- The company has only one class of stock
- All shareholders agree to the S Corp election and sign and submit Form 2553 Election by a Small Business Corporation
If a company doesn’t meet any of the above requirements (too many shareholders, having foreign shareholders, etc.), the IRS will cancel the S Corp election status, and the company will be taxed as a C Corporation.
Corporations and LLCs that elect S status are usually deemed an S Corp in their home state. However, not all states and municipalities recognize S Corps. Texas, the District of Columbia, New Hampshire, Tennessee, and New York City do not recognize the S Corp’s special tax treatment and are therefore taxed as C Corps. Louisiana also taxes S Corps as C Corps, with some exceptions. Check with your accountant to make sure you’re compliant with tax law.
And that’s also good advice when considering taking an S Corp election. It’s crucial to review the obligations involved in keeping an S Corp compliant and how part of that pertains to the reasonable compensation requirement.
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