, but death doesn't get worse every time the legislators or regulators come together.
As an S corporation officer/shareholder―particularly if you work in the business―your compensation is generally considered wages for the purpose of calculating federal income and payroll taxes. Reasonable compensation is not a dividend or a distribution. While this position is not particularly new, a recent IRS notice reminds taxpayers of the rules and also indicates that the IRS is focusing on this issue.
In addition, certain health care premiums paid by the S corporation, although not subject to unemployment taxes, are reportable as part of your wage income on your personal tax return.
The issue is of concern to the IRS because employment and income tax liabilities depend on how any payments to an officer/shareholder are categorized.
Why should you care? The consequences of being wrong can be considerable, including sizeable new penalties for late and incomplete tax filings, additional employment tax liabilities and associated penalties―and erroneous 1040s that must be amended, possibly with additional taxes due.
Taxability of Payments as Compensation
S corporation officers are considered employees under both the Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA), and therefore are subject to withholding for federal employment taxes. A recent IRS notice indicates that this is an area of increased IRS scrutiny.
The Internal Revenue Code also considers S corporation officers to be employees for the purpose of federal income tax withholding. According to the IRS, "S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages."
The fact that an officer of the company is also a shareholder does not change these requirements.
Reasonable Compensation
Distributions and payments of cash and property to an officer/shareholder must, for federal tax purposes, be considered compensation to the extent that the amounts are "reasonable compensation for services rendered to the corporation."
The IRS has not provided specific guidelines for determining reasonable compensation, but it has published a list of various factors considered by the courts in determining reasonable compensation, as follows:
training and experience
duties and responsibilities
time and effort devoted to the business
dividend history
payments to employees who are not shareholders
time and manner of paying bonuses to key people
the amount that comparable businesses pay for similar services
compensation agreements
use of a formula to determine compensation
While there is no definitive guidance, relatively low salaries―particularly in conjunction with higher income and distributions―will be subject to IRS scrutiny.
Taxability of Benefits
S corporations that pay accident or health insurance premiums on behalf of certain shareholders―those who own more than two percent of the company―are required to report the amount of such fringe benefits as wages on Form W-2. The shareholder must also report the amount of the premiums as gross income on his or her personal income tax return. While these amounts are subject to income tax withholding, they are not subject to FICA or FUTA. Note that health insurance premiums can either be paid as part of a company plan or be reimbursed by the company, if the officer/shareholder provides adequate documentation.
The amount of insurance premiums paid on behalf of shareholders is deductible by the corporation as a fringe benefit, as long as it is reported on both Form W-2 and Form 1040.
Penalties
If an S corporation is found to have filed a late return or a return that doesn't show required information―such as omitting or incorrectly reporting shareholder distribution amounts and dates―the corporation is subject to penalty and interest. The current amount of the penalty (indexed for inflation) is $85 per shareholder, per month, for a period of up to 12 months.
Also, if a shareholder underreports income on his or her personal return as a result, the shareholder must file an amended return and pay any additional income and employment taxes due, plus any applicable penalties and interest.
