Do you operate your business as an S corporation? If you work for the corporation, you generally must take a salary. An officer who performs more than minor services for a corporation, and who receives remuneration in any form, is considered an employee and is subject to employment taxes. In recent years, the IRS has become more aggressive in auditing S corporations on this point. Below is a recent case that illustrates some of the issues involved in S corporation compensation:

Facts of the Case

Glass Blocks Unlimited was an S corporation with Frederick Blodgett as its president and sole shareholder. As the name implied, the corporation sold and distributed “glass blocks” for the real estate market. Blodgett worked full-time for the corporation. There were no other full-time employees, but the company used day laborers.

With the downturn in the real estate market, the business experienced financial difficulties, and Blodgett transferred funds to the company in order to cover operating expenses and other costs. In 2007, he transferred $30,000 from his family trust. His fiancé at the time contributed $15,000 in 2007, and an additional $10,000 in 2008.

Blodgett took no salary in 2007 or 2008, but did take distributions of not less than $30,844 in 2007, and $31,644 in 2008. For 2007, the corporation reported gross receipts of $832,579 and net income of $877; for 2008, gross receipts were $701,388 and net income was $8,950. The corporation also reported the repayment of $29,132 of loans from shareholders in 2007 and $8,391 in 2008. Loans from shareholders were shown on the balance sheet on the return.

Blodgett did not have any other employment during 2007 or 2008, and the only income he reported on his Form 1040 was the pass-through income from the S corporation and $11 in interest income.

In an employment tax audit, the IRS determined that Blodgett should be classified as the taxpayer’s employee and that the distributions ($30,844 for 2007 and $31,644 in 2008) constituted wages for which FICA taxes should have been paid.

The court noted that for employment tax purposes, wages are defined as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash” (with certain exceptions). The critical fact is whether a payment actually received is remuneration for employment. The court noted Blodgett was the taxpayer’s only officer and performed substantially all of the work necessary to operate the business, and his services generated all of the corporation’s income.

The taxpayer contended a portion of the distributions represented repayment of loans between itself and Blodgett and should not be considered wages. According to him, transfers to the corporation of $45,000 in 2007 and $10,000 in 2008 were loans. The IRS argued they were contributions to capital. The court considered the factors when evaluating whether amounts transferred to a closely held corporation are loans or capital contributions, and sided with the IRS in finding they were not bona fide loans.

The taxpayer also argued that $15,680 would be reasonable compensation based on a 20-hour week and a salary of $15.25 per hour. The court found Blodgett’s involvement in the business was more substantial, and that he worked more than 20 hours a week. Finally, even at $15.25 per hour, the salaries of $30,844 and $31,644 were reasonable for a full-time employee. The court allowed the IRS’s computation of the employment tax, as well as penalties for failure to deposit taxes and failure to file employment tax returns. (Glass Blocks Unlimited, T.C. Memo. 2013-180)

Lessons from the Case

This isn’t the only case involving insufficient salaries from S corporations. What makes this one interesting is that the court allowed the full amount of the distributions to be classified as salaries, despite the fact that the business was only nominally profitable at the time.

Clearly, reporting no salary on the line for officers’ compensation on Form 1120S is asking for trouble. But how much of a salary should you take? That’s not an easy question. A professional with an advanced degree who takes a salary of $30,000 a year for the full-time management of an S corporation generating $500,000 in net income would be suspect. But taking a salary of $175,000 a year for a 40-hour week might not be. In arriving at a reasonable salary, the IRS and the courts could look at a number of factors, including the nature of the work performed, the success of the business, past salary, comparisons of the employee’s salary to those paid by similar companies for similar services, the character and condition of the company, time spent, potential conflicts of interest, presence of a contract or formula for determining salary, loan restrictions, etc.

If the business requires additional capital (for example, because it’s expanding) and the profits are plowed back into the business, you may be able to justify a smaller salary. Taking distributions suggests the business doesn’t need the cash, and it’s a way to compensate the officer/shareholder other than through salary. On the other hand, in a business with a large capital investment, an officer/shareholder might be able to justify the distributions as a return on investment. That’s particularly true if prior disbursements have been small because of cash flow problems.

What if you really have little involvement with the business? You might want to document your time on other activities, whether spending time at your vacation home or working at another business. But before doing so, you might want to consider the 3.8% net investment income tax on passive income generated from partnerships, S corporations, etc. Claiming you don’t materially participate in the business would subject you to the tax.

 

For More Information

Please contact your DS&B representative or email ask@dsb-cpa.com to be connected with a certified professional.

 

Disclaimer: All content provided in this article is for informational purposes only, and is subject to change. Contact a DS+B professional before using or acting on any information provided in this article.