Common Tax Audit Issues | Corporate Shareholder-Employee Compensation

Corporations often have shareholders who are also employees. S Corporation versus C Corporation strategy, for shareholder-employee salaries are often polarized secondary to IRS regs. So, in a tax audit, for an analgous shareholder-employee, S Corporations would have to justify a low salary, while C Corporations would have to justify a high salary. So let’s look at at Wilmington NC CPA Firm, our hypothetical company, to examine this issue.

S Corporation Perspective: Distributions vs. Wages

Assume Wilmington NC CPA Firm, our demo company, is an S Corporation. Non wage distributions to shareholders are subject to income tax on IRS Form 1040 (via Schedule K-1 on IRS Form 1120S). But not to self employment taxes. This is a loophole and the subject of IRS tax audits. Wages, up to the Social Security tax cap, say $107,000, are subject to both income tax and employment tax (15.3% - half from the shareholder, half from the S Corporation).

So every $1,000 of distribution saves $1530 of employment taxes, up to an annual salary of $107,00. And then $290 for the portion of the salary over $107,000.

Shareholder-employees usually receive a mix of salary and distribution as compensation. Obviously, both the shareholder and Wilmington NC CPA Firm want the highest distributions and the lowest salary possible. Saving a combined $15,300 on every $100,000 of distributions is strong incentive. This has been one of the biggest loopholes in small business acounting for decades. But the IRS doesn’t like giving up those taxes. And in a tax audit, the IRS can re-characterize employee-shareholder distributions as wages, triggering years of back payroll taxes. Worse, the IRS is in the process of performing highly publicized tax audits of Form 1120S tax returns to look at this issue.

There are no absolute IRS guidelines on shareholder-employee wages that Wilmington NC CPA Firm can rely on to avoid this trap during a tax audit. But there are suggestions it provides involving;

• The employee’s qualifications.
• Comparison to salaries paid by other CPA firms in Wilmington.
• Employee’s responsibilities.
• Salary/distribution ratios.
• Salary compared to available cash flow etc.

So in a tax audit, if the shareholder-employee is both a CPA and tax manager, the IRS would expect a higher salary than if he/she was an accountant limited to tax preparation.

If you need an initial free consult with a CPA practicing in a Wilmington NC Accounting firm, please consider calling us at (910) 399-2705.

C Corporation Perspective

Assume Wilmington NC CPA Firm is a C Corporation. Now it wants to pay the employee-shareholder more wages and less dividends (distributions). Dividends currently have a maximum tax rate of 15%. But the tax on dividends is expected to default to the shareholder-employee’s personal marginal tax rate. So, potential tax on $1000 of dividends may increases $200.

Opposing Perspectives

On a tax audit, if Wilmington NC CPA Firm is an S corporation, it would have to justify a low shareholder-employee salary. But as a C Corporation, it would have to justify a high shareholder-employee salary. Again, no absolute IRS guidelines exist on this issue.

Proactive Documentation

Every year, the corporate minutes should proactively document the factors influencing the salaries of shareholder-employees. Ironically during a tax audit, for an analogous shareholder employee, an S Corporation builds a case for a low salary while a C Corporation builds a case for a considerably higher salary. And both can be justified!

NC Tax Forms

Remember that the NC CD401S for S Corporations and NC Form CD 405 for C Corporations have to be considered, making these compensation issues more complex. A NC tax audit deserves respect.

We’re a CPA run Wilmington NC Accounting firm offering tax preparation and IRS tax audit representation. For a free initial consult, please call us at (910) 399-2705. We understand tax preparation is just one component of small business accounting.