By Jack Salewski, CPA, CGMA & Paul S. Hamann
There are numerous issues when a business owner is a shareholder in more than one S Corp. Does the shareholder have to complete a reasonable compensation assessment (RCA) for each corporation, or will one assessment do? Does each corporation need to pay wages? What happens if the owner is above the Social Security maximum?
How many Reasonable Compensation Assessments are needed?
Each entity should have its own RCA, even if the shareholder is performing exactly the same services and devoting the same amount of time to each entity. There a couple of reasons this makes sense.
First: Each entity should have research and documentation as part of the RCA. This way, if reasonable compensation is challenged, each entity has protected itself, and ideally, added the research and documentation to the corporate minutes.
Second: If the two entities are in different locations, the salary may vary. For example, a financial planner in New Haven, CT will have an RCA of $147,000, while a financial planner in Golden, CO (all services and time devoted to the business being identical) will have an RCA of $121,000. If the Golden location was used in this case, reasonable compensation would be understated. If the New Haven location was used the compensation would be overstated.
In some instances, a single shareholder may need to run two RCAs, such as when he works from two different locations. Turn the above example around: If one shareholder is splitting his time between two locations, New Haven, CT and Golden, CO, he should run an RCA for the time spent at each location.
If the entity is an S Corp the total time can be capped at 40 hours per week (See McAlary v. IRS). By way of example: if the above financial planner was working 30 hours per week (60% of their time) in Golden and 20 hours a week (40 % of their time) in New Haven, then the Golden RCA would reflect 24 hours a week (60% of 40-hour cap) and the New Haven RCA 16 hours a week (40% of the 40-hour cap).
Travel time between businesses could be allocated in the same percentage as time spent at each location, or equally among each entity, whichever is the most reasonable.
Should each entity pay wages?
If a shareholder is over the Social Security maximum in aggregate, each corporation would have to withhold and match 6.2% of wages up to $118,500. When the shareholder files her individual tax return, to the extent her total wages are over $118,500, the Social Security that has been withheld will be converted to federal withholding. The corporate portion of the social security will be an extra expense of the business.
Unemployment tax is another consideration. Most states charge unemployment tax based on a percentage of wages up to a maximum amount. If each corporation is paying wages, each corporation will pay the maximum unemployment tax.
One solution is to form an employee leasing company to pay all employee-related expenses for all the shareholder’s other entities. This new entity charges each company a fee to cover the costs of the employees. The employee leasing company would cover all employees, not just the shareholder(s) because these issues relate to all employees, not just shareholders.
Let’s compare and contrast:
- For simplicity, the only employee is the sole shareholder.
- Four corporations
- Unemployment tax is 2% of the first $12,000 in wages
- Corporation 1 reasonable compensation $75,000
- Corporation 2 reasonable compensation $60,000
- Corporation 3 reasonable compensation $80,000
- Corporation 4 reasonable compensation $25,000
Company share of Unemployment
Social Security Tax
Corporation 1 $4,650.00 $240
Corporation 2 $3,720.00 $240
Corporation 3 $4,960.00 $240
Corporation 4 $1,550.00 $240
Total $14,880.00 $960
If all wages were paid
Through the leasing
Company $7,347.00 $240
By using this technique there would be a total savings of $8,253 (14,880+960-7,347-240).
When using the employee leasing company concept, line 7 of each corporation would reflect the reasonable compensation as determined by the RCA. The balance of what is paid to the employee leasing company would be reflected as employee lease expense. If there are other employees, their wages would be reflected on line 8 of the 1120S.
As with any related party transaction, there should be a signed written contract as well as proper documentation in the corporate minutes.
An ancillary benefit to this method is the time savings and minimizing the risk of making a late payroll tax deposit and payroll reports if payroll is prepared internally. If the payroll is prepared externally the cost of payroll preparation should be reduced.
Sometimes it’s just not practical to set up an employee leasing company. If the taxpayer had just two corporations, setting up and running a third corporation is a lot of work for the amount of savings. In cases like this, all payroll could come out of one corporation. Then that corporation would charge a fee to the second corporation to cover all payroll-related expenses. The fee that the corporation was charged would be reflected on line 7 of the 1120S.
Clearly, this needs to be documented in the minutes of both corporations.
If none of the employees, including the shareholder, is above the Social Security maximum in aggregate is any of this needed? Yes and no. Yes, an RCA needs to be made for each corporation. No, it is not necessary to set up an employee leasing company or have one company do the entire payroll and charge back fees to the other company. Your own business analysis will tell you if the time and risk of processing payroll in one company is worth it.
Consider that best practices are proactive, not reactive. Taking on complexities gradually is less burdensome than trying to fix a problem later. There is always a chance that the client’s aggregate wages will go over the Social Security maximum and you will not know it until months after or even a year after the fact.
At the end of the day, as our client’s “trusted advisor,” we need to guide our clients to do proper due diligence backed up with proper documentation in respect to reasonable compensation.