By Paul S. Hamann & Jack Salewski, CPA, CGMA
What is the correct treatment of Director’s Fees? Is it a W-2 or a 1099? Let’s take an in-depth dive into this question.
If you were to look at the issue without a lot of critical thought you might conclude that the Director’s compensation should be reported on a W-2. Your reasoning would be this: In order for the compensation to be reported on a 1099 the Director would need to be independent of the corporation. How can a Director be truly independent of a business that they influence and guide?
The distinction missing from this analysis is that the Director is not “controlled by” the corporation but “directs” the corporation. The Directors are paid for their “independent thought, guidance and expertise.”* This is true even if the Director is an employee for other services rendered. Even the Internal Revenue Service’s website indicates Director’s fees are considered self-employment income.
Because the Director is considered as being in the “business” of being a corporate director, any ordinary, necessary and reasonable expenses as well as the Director’s Fee income would be reported on the individual’s schedule C. This would also mean that the Director may be able to set up a retirement plan to offset some of this income. If the Director is also an investor in the business, expenses will need to be allocated between director expense on schedule C and investor expenses on schedule A.
*A word of caution on Officers. Officers and Directors are not the same. Officers are controlled by the corporation and would be considered employees. For more see Blodgett T.C. Memo 2012-298
1099 or W-2 for Shareholder-employees of S Corps?
1099 or W-2? That’s the top 10 question Jack receives here at RCReports.
We hear your rebuttal: Paying wages via 1099-MISC instead of W-2 has no tax effect! True, if you’re considering only FICA taxes. However, other government entities, both state and local, also want their slice of the pie.
Regardless, there’s no need to even analyze the impact, because the real reason shareholder-employees of S Corps must be paid wages reported on form W-2is simple:
It’s the law.
FS-2008-25 states: 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.
Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.
Just to be certain we looked up the IRS definition of Employee and Independent Contractor, just to make sure there wasn’t some loophole or wiggle room to argue for independent contractor status.
Employee: Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
Independent Contractor: The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
Nope. It is hard to argue you don’t have control of what will be done and how it will be done.
What this means to your pocketbook:
The IRS takes this issue very seriously and does not hesitate to assess hefty interest and penalties to folks who don’t comply. The IRS will reclassify all 1099-MISC payments made to S Corp owners as W-2 wages. This means that there are several months, sometimes even years of payroll taxes that the S Corp will now have to pay including the following:
- Back taxes for payroll taxes;
- Interest on payroll taxes;
- Penalties for failure to file quarterly Forms 941;
- Penalties for failure to timely pay the tax withholding to the IRS;
- Penalties for failure to file and issue Form(s) W-2;
- PLUS Back taxes for state and local payroll filings, interest, and penalties.
Jack believes even the argument to pay real estate agents as independent contractors run into trouble.
It is a fact that real estate agents can be paid via a 1099. That being said this exception is for the work as a real estate agent. The services that are being performed for other services to the corporation must be on a W-2. So there are two options here:
- Issue a 1099 for real estate services and issue a W-2 for all other services or
- Put all compensation on a W-2.
Since it would be more efficient to put everything on a W-2, put all compensation on the W-2.
This being said there are times when it may make more sense to beg for forgiveness than to comply.
This will be the case when a client comes in after year end and after the filing deadline to timely file the payroll tax returns. In a case like this if you file the payroll reports late there are going to be lots of penalties. This is a case to file a 1099 for the shareholder. The shareholder will then pick up the income on the individual tax return as Schedule C income, subject to self-employment tax. There may be a penalty for late filing of the 1099, however, that will be less than the penalty for late filing and late paying of payroll tax returns. It is important that the taxpayer at this point starts to do payroll correctly. Most agents will see that the taxpayer is trying to be compliant and will be reasonable.
On a side note, here at RCReports we have seen as many, if not more, taxpayers get caught up in an IRS Reasonable Compensation challenge that was initiated at the state level. States generally have more at stake when it comes to Unemployment tax and some states are aggressively going after that revenue. When the state successfully forces the taxpayer to re-categorize 1099-MISC payments as W-2 wages the audit train begins rolling – next stop the Internal Revenue Service. And over the last two years, Reasonable Compensation challenges initiated by the IRS have been coming mostly as a result of payroll audits. The examination begins by looking at 1099 contractors, but be advised, examiners are trained on Reasonable Compensation, so a simple request on how the S Corp owner determined his/her salary escalates easily into a Reasonable Compensation challenge.
Mastering the Rules of S Corporation Shareholder-Employee Compensation
I am honored to co-present this course with my friend and Reasonable Compensation expert Stephen Kirkland. Please join us for a look at Reasonable Compensation for S Corps and a preview of what is headed your way in 2018.
The issue of Reasonable Compensation will certainly play a much bigger role in your practice in 2018, spreading beyond S & C Corps to include LLC’s Partnerships and Sole Proprietors.
Make sure you are on target with your S Corps for 2017 and get a glimpse of what to expect in 2018. Hope to see you on the 31st.
Presented on January 31st by Strafford Seminars. Register HERE