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1099 or W-2 for Shareholder-employees of S Corps?

By Paul S. Hamann & Jack Salewski, CPA, CGMA

1099 or W-2?  That’s the top 10 question Jack receives here at RCReports.

Answer: W-2

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:

  1. Back taxes for payroll taxes;
  2. Interest on payroll taxes;
  3. Penalties for failure to file quarterly Forms 941;
  4. Penalties for failure to timely pay the tax withholding to the IRS;
  5. Penalties for failure to file and issue Form(s) W-2;
  6. 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.

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