S corporation (S Corp) taxation is a popular election for many business owners who originally decide to form an association (corporation) or limited liability company (LLC). Some major advantages of S corp status are:
- a single layer of tax applied at the individual level also referred to as pass-through taxation and
- tax-favorable characterization of income such as a portion of earnings protected from the brutal self-employment taxes.
The S corp was created in the 1950s amid very high corporate and individual taxes. The top income tax rate in 1958 was 52 percent for corporations and 91 percent for individuals (not a typo, the effective tax rate for corporate dividends could be as high as 96 percent!)
Under the Eisenhower administration, Congress enacted legislation creating subchapter S of the Internal Revenue Code that adopted a simplified domestic entity classification to face the crippling tax situation for small business owners in America. Soon after Congress’s action, the issue of self-employment taxes was raised, and the Treasury made taxpayers aware through Revenue Ruling 59-221 that the amount of income that is required to be passed through to each shareholder’s gross income does not constitute “net earnings from self-employment” for Self-Employment Contributions Act purposes. This constituted a windfall to taxpayers and contributed to the popularity and growth of the S corporation’s use by small business owners.
This prompted S corporation owners to classify all of this newly founded pass-through income as dividends. The government did not like that either, and about 15 years later, the Treasury clarified its position in Revenue Ruling 77-44. The ruling stated that to the extent that an S corps’ owners perform services for the company, then the company is required to pay the owner a reasonable salary for those services. Additionally, the reasonable salary is subject to the self-employment tax. Unfortunately, the government gave little guidance for taxpayers and practitioners on how to determine the reasonableness of an owner’s salary. Instead, the government left it for the courts to decide … and after another 40 years … it appears that they did.
After Revenue Ruling 77-44, the IRS responded aggressively to S corps that failed to pay any salary to their owners. As a result, the case law became clear that in these circumstances any and all distributions that were paid to owners would be reclassified as wages and subjected to self-employment tax. Because of the devastating results of these enforcement efforts, CPAs and tax professionals quickly responded by advising clients to pay a salary. However, the public was still left to its own devices in determining if the amounts were reasonable. Some taxpayers and tax professionals were overly conservative and others overly aggressive. As a result, there has always been a great disparity in salaries between taxpayers, even ones operating in the same industry and regions of the country, and this disparity has not gone unnoticed by the Treasury Department.
In 2005, the Treasury Inspector General for Tax Administration (TIGTA) issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed the following:
- Approximately 80 percent of all S corporations were more than 50 percent owned by one shareholder, giving that shareholder control in setting his or her compensation.
- Owners of single-shareholder S corporations paid themselves salaries equaling only 41.5 percent of the corporation’s profits, down from 47.1 percent in 1994.
- There were 36,000 situations in which the sole owners of S corporations generating more than $100,000 of income took no salaries. These corporations passed through $13.2 billion to their owners free from payroll tax.
- In total, the payroll taxes paid by single-shareholder S corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.
Does this sound like a call to action to you?
Better believe it.
Following the 2005 TIGTA report, a case against an accounting firm, JD & Associates, was heard by the tax court, and it did not end well for the taxpayer. In JD & Associates, Jeffrey Dahl was the sole shareholder of an accounting firm taxed as an S corporation. Dahl was a CPA with more than 20 years of experience. He was responsible for making the firm’s hiring decisions, paying its bills, maintaining its books and records, preparing its tax returns, and preparing and reviewing tax returns for the firm’s clients. The courts in this decision increased the salary almost 300 percent in each of the years under consideration.
In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance echoed the concerns expressed in the TIGTA findings. The GAO report noted that in 2003 and 2004 combined, S corporations had underreported their shareholder compensation by $24.6 billion, with corporations with fewer than three shareholders responsible for nearly all the underreporting.
Following the 2009 report to the Senate Finance Committee, a case against another CPA, Davis Watson, was heard by the tax court. It also did not end well for the taxpayer.
Do you think that the government was sending a clear message to the business community by taking action against accountants and CPAs?
Do you think that they looked at the accountant’s clients too?
Better believe they did.
So how much is enough?
Whereas JD & Associates and Watson affirmed that the IRS had the authority to reclassify distributions as wages, it still left practitioners and taxpayers largely on their own in determining a reasonable amount of salary to pay.
Enter Sean McAlary LTD, Inc.
First, let me say that this also did not end well for the taxpayer. However, in this 2013 case against a realtor in southern California, the tax court finally provided some bright lines and insight for taxpayers and practitioners to better support decisions related to setting S Corp salaries. The case highlights the factors that the court will weigh in making its reasonable salary determination, including:
- Compensation of Non-Owner Employees
- Past Salary History
- Industry Formulas
- Travel Requirements
- Personal Guarantee of Debt
- Key Relationships and/or Contracts
- Financial Condition of Your Company
- Distribution History
Although all these factors are considered, the court’s most heavily weighted consideration appears to be summarized as the replacement cost to the company of hiring an outside party to perform the business owners’ duties. The court considered three key factors in support of the replacement factor:
- Is there a methodology that can be duplicated?
- Is the methodology grounded in reliable empirical data?
- Is there a measure of the duties that the owner has performed and their proficiency at those duties?
Using this three-legged approach, taxpayers can now assess the value of the services that they provide a company in exchange for their salary payments. If you operate as an S Corp, and you have not reviewed your approach to setting salary since 2013, then I encourage you to do so. You may have significant exposure to an IRS examination; however, you also might be subjecting yourself to more self-employment tax than is required under the law.