What is a Reasonable Compensation for Owners of S Corp?

What is a Reasonable Compensation for Owners of S Corp?

If you have read many of my columns over the years, you probably know that a “S Corporation” is the preferred entity for most alarm companies with a single, or few, individual shareholders. As you may already know, An S corporation is a type of corporation that passes its taxable income, credits, deductions, and losses directly to its shareholders. This means that the corporation itself is not taxed on its income, but instead, the shareholders are taxed on their share of the corporation’s income. The S corporation election is available only to small businesses with 100 or fewer shareholders, and is an alternative to the limited liability company (LLC)

On the other hand, a regular corporation, also known as a C corporation, is a separate legal entity from its owners. It is taxed as a separate entity, and its shareholders are taxed on any dividends they receive. C corporations are subject to double taxation, which means that the corporation is taxed on its income, and then the shareholders are taxed on their share of the corporation’s income when they receive dividends.

S Corporations are preferred for several reasons, but a key consideration for an alarm company is the taxation of an eventual sale of customer monitoring agreements. Many Tax Professionals who aren’t familiar with the alarm profession don’t realize that this is many times the owners “retirement plan.” When an S Corporation sells, the alarm accounts are substantially taxed as capital gains at the shareholder level. The owner(s) pay tax on their share of the gains and it’s over. When a C Corporation sells RMR, the transaction is first taxed at the corporate level, then taxed again when the remaining funds are distributed to the shareholder(s). In California the tax rate on the sale of C Corporation assets can exceed 60%.

Since the earnings of an S Corporation pass through to the shareholder(s), they can distribute them each year without any additional tax consequences in most cases. Since these earnings are not wages, it is tempting for owners, not to take a salary so as to avoid Social Security (FICA) and Medicare. Because of this the IRS requires that active shareholders take a a reasonable salary from their S Corporations. For most tax payers the first $168,600 of wages are subject to FICA and the IRS wants to see active shareholders paying in their fair share. Officer salaries are reported on line 7 of an S Corporation Tax Return, and the IRS looks for numbers that are low in comparison to the gross receipts of the Corporation.

So how much compensation is enough?

The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation’s gross receipts.

The three major sources are:

1. Services of shareholder

2. Services of non-shareholder employees or

3. Capital and equipment

To the extent gross receipts are generated by services of non-shareholder employees and capital and equipment, payments to the shareholder would properly be treated as non-wage distributions that are not subject to employment taxes. But to the extent gross receipts are generated by the shareholder’s personal services, then payments to the shareholder-employee should be classified as wages that are subject to employment taxes.

In addition to gross receipts generated directly by the shareholder-employee, the shareholder-employee should also be subject to wage treatment for administrative work performed by him for the other income-producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.

Some factors in determining reasonable compensation:

  • 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
  • The use of a formula to determine compensation

In determining your reasonable compensation, keep the above in mind and be ready to substantiate your salary.