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Form 1120-S CPA tax accountant discusses S-Corporation Officer Wages | Reasonable Compensation | Form 1120S Instructions

Form 1120-S CPA Wilmington NC

Gary Bode, CPA: reasonable compensation to S Corporation shareholder officers is an IRS dilemma with no absolute guidelines. For a free phone consult, please call 399-2705.

S Corporation CPA tax accountants know the IRS Form 1120S instructions don’t cover all the bases. What’s the best way to get audited on your S Corporation? Most Form 1120-S CPAs will say it’s showing no “Compensation to Officers,” on Line 7 of Form 1120S. Compensation to officers means formal payroll, as opposed to distributions. Compensation is subject to income and payroll taxes. Distributions incur income taxes but avoid payroll taxes for both the shareholder officer and the S Corporation itself as an employer.

Distributions

When I first can across this issue, I didn’t understand why the IRS cared about payroll taxes. Especially since distributions incur income taxes. But they do care. Every few years the IRS issues “promotion PR” to encourage “proper compensation” to shareholder officers.

Here’s why the IRS cares about S Corporation officers receiving distributions instead of payroll. Every $1,000 of distribution to an officer, instead of payroll, generally saves $153 of payroll taxes. Remember that’s split between the officer and S Corporation. But in smaller S Corporations the officer is the S Corporation. Here’s the break down.

  • The S Corporation with holds 6.2% of the gross wages from the paycheck for Social Security.
  • The S Corporation with holds 1.45% of the gross wages from the paycheck for Medicare.
  • Eventually the S Corporation “matches” the 6.2% of Social Security.
  • Eventually the S Corporation “matches” the 1.45% of Medicare.

“Hidden” payroll costs to the S Corporation

Besides the “matching” Social Security and Medicare employer taxes mentioned above, the S Corporation has other payroll related obligations on wages:

  • State Unemployment Taxes: In some states that can be more than $1000 per year per employee.
  • Federal Unemployment Taxes: The base is $42 per year per employee. But many States pay an additional amount thanks to the Recession.
  • Workman’s Compensation: note many officers opt out of WC.
  • S Corporation pension plan contributions.
  • S Corporation paid health insurance premiums.

“The IRS expects a S-Corporation officer to have reasonable compensation. The question is what’s reasonable? The answer? It depends.” 
– Gary Bode, Form 1120S CPA and tax accountant

So what if the S Corporation Officer Shareholder takes all of his/her wages as Distributions?

Well, on an IRS tax audit they could redefine all distributions as compensation. That means years of back payroll taxes.

Appropriate S Corporation Officer Shareholder Compensation Depends on What?

Well, that’s the heart of the matter. Each situation is different. There’s no guidance in the Form 1120S instructions. And the IRS doesn’t have absolute guidelines. But they’ve published a Fact Sheet, which lists these factors that tax courts have considered in determining reasonable compensation after a contested audit:

  • The S Corporation officer’s training and experience.
  • Duties and responsibilities.
  • Time and effort devoted to the business.
  • Dividend history.
  • Payments to non-shareholder employees.
  • Timing and manner of paying bonuses to key people.
  • What comparable businesses pay for similar services.
  • Compensation agreements.
  • Use of a formula to determine compensation.

I might add:

  • Available cash flow to pay salaries. But, the IRS may prefer a loss on Form 1120-S than too low of a payroll figure.
  • How long the company has been in business. The first few years are always problematic.

Given the above list, many S Corporation officers can see where the IRS is coming from and adapt to it. Most Form 1120-S CPAs have good experience interpreting these factors into a defensible wage/distribution ratio.

A Cautionary Note – Document the Distributions your Company Makes

I would ask your CPA how to document distributions proactively in the Corporate minutes, to help if audited. This isn’t a common topic conversation among us, and I suspect it isn’t discussed much with clients either. But in an audit, the reasoning behind company decisions, if documented contemporaneously, can help your case.

Oh, No!

A recent bill requiring that all distributions in Personal Service Corporations (the preferred form of business entity for CPAs) be subject payroll taxes actually made it to the Senate floor. Fortunately, it died. But I think the IRS will exert pressure to get it reconsidered. My fear? They’ll use us to start closing the distributions/wages loophole.

I’m a S Corporation CPA tax accountant with a virtual office to serve long distance and international clients.

We can’t all live in wonderful Wilmington, NC after all. I run our firm as an S Corporation so I stay current on emerging S Corporation issues.There are hundreds of postings on this website. What you read is what you get. If you have a Form 1120S question, give me a call for a free phone consult at (910) 399-2705.

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1 comment to Form 1120-S CPA tax accountant discusses S-Corporation Officer Wages | Reasonable Compensation | Form 1120S Instructions

  • Gary Bode CPA admin

    I’m sorry the return is too complicated for most folks to self prepare Michael. I’m not really trying to drum up business here. It’s just a comprehensive speciality. Most clients, I think, feel a CPA covers those bases for them better. Generally, the tax savings exceed the fees. Wish I could be more help, but your comment isn’t very specific.

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