Wednesday, April 27, 2011


Shareholders of an S corporation love receiving distributions of profits because there is no immediate tax consequences...however, guess who has an issue with this?  You guessed it...the IRS!  They have taken a long standing position that where the shareholder is also acting as an employee of the corporation, "reasonable" compensation must be paid.  And guess what...this compensation is also subject to Medicare and Social Security  taxes whereas shareholder distributions are not.

The classification of S-Corp payments to shareholders is a long standing compliance issue with the IRS. They feel that many taxpayers convert what would otherwise be self-employment income (wages) to distributions, in order to avoid self-employment tax (Medicare and Social Security).

This past December the IRS was successful at convincing a US District Court that an S Corp shareholder-employee's $24,000 salary was not "reasonable" and allowed the IRS to reclassify as salary over $67,000, resulting in additional Medicare and Social Security you would guess...penalties and interest were tacked on as well!

According to IRS fact sheet #2008-25 a list of factors has been issued to help determing whether "reasonable" compensation has been paid.  They include:
  • 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; and
  • use of a formula to determine compensation.
By carefully addressing these factors, preferably in a written document, the chances of the IRS attacking your determination of "reasonableness" should be significantly reduced.  Please review your situation and feel free to contact our office with any questions you might have concerning this very delicate requirement.

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