Phoenix CPA Firm

Glendale Accountant | S Corp Officers

The IRS is starting to scrutinize S-Corporations officer’s compensation to verify that they are taking what they believe to be a reasonable compensation. They are also starting to scrutinize the timing of the compensation. The reason for this is the IRS believes there has been a tax avoidance by the officer’s not taking, or taking what they believe to be to small of a salary. This is because the officer’s are taking distributions in lieu of a paycheck, and these distributions are not subject to payroll taxes. The instructions for the form 1120S (the tax return filed by an S-Corporation) states that “Distributions and other payments by an S-Corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

Here are the factors the courts have ruled on when determining what is a reasonable compensation:

  • The character and financial condition of the business
  • The role the shareholder plays in the business
  • The corporation’s compensation policy for the other employees
  • The shareholder’s salary history
  • How the compensation compares with similar employees of a like business
  • Conflicts of interest in setting the compensation levels
  • Whether a hypothetical investor would determine the return on the investment to be adequate
  • The shareholder’s qualifications
  • Size and complexity of the business
  • Ratio of salary taken to sales and net income
  • Ratio of salary taken to distributions taken
  • Whether the shareholder guaranteed the corporation’s debt
  • Timing and manner of paying bonuses to key people

This is not every factor the IRS can use in determining whether or not adequate compensation was taken.

Something the IRS has begun to look further into is the timing of compensation taken during the year. Compensation taken throughout the year and being called distributions or loans until the end of the year when it is converted to payroll, is now not something the IRS approves. The IRS also frowns upon taking one lump sum payment at the end of the year. The IRS may determine that these payment should have been paid periodically and hit the corporation with late payment penalties for the payroll taxes that were paid at the end of the year.

Officer’s compensation should be what a normal person in a similar position in a similar company would take. The compensation should also be taken periodically through the year.

If you would like to discuss this further or get more information, feel free to contact us at Dusseau & Makris, PC, your Phoenix CPA firm.