15 Aug Reducing and Documenting Reasonable Compensation
We are currently navigating troubled waters to say the least. Many business owners including S Corporation shareholders are finding themselves trying to make ends meet. You may be even going as far as considering taking less of a salary to keep funds in your business in order to pay your expenses. Some people have expressed concern, however, that they cannot take less of a salary for fear of violating the “reasonable compensation” standards. So, the remainder of this post will examine S Corporation principles, reasonable compensation background, and documentation to support salary adjustments.
S Corporation Principles
As many S Corporation shareholders know, one of the main benefits of being an S Corporation shareholder-employee is a reduction in payroll taxes. Corporations are separate taxable entities that do not pass through income and/or loss items to shareholders. Partnerships and sole proprietors including LLCs taxed as such pass-through net income that is entirely subject to self-employment taxes.
S Corporations on the other hand can pay a salary subject to payroll taxes, and the profits after the shareholder’s salary are not subject to payroll taxes. The S Corp’s net income is passed through to the shareholder and taxed at his/her rate regardless if money is actually distributed from the business.
Example: Joe is the sole shareholder of Corp 1, an S Corporation. Corp 1 has net income of $100,000 before Joe’s salary. Joe does a reasonable compensation study and determines a reasonable compensation is $50,000. The $50,000 salary will be subject to payroll taxes while the remaining $50,000 of net income will only be subject to federal income taxes. This is an overall tax savings of over $7,650 compared to single member LLC disregarded entity.
If you are thinking, “That sounds like a great deal. I’m not going to pay myself anything and have an even bigger tax savings,” your thought and effort is applauded. However, the IRS requires that S Corporation shareholder employees are paid a reasonable compensation. The difficult part that has been argued for years is what amount or standards are used to determine what a reasonable compensation amount is. Treasury Regulation 1.162-7(b)(3) defines reasonable compensation as “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” IRS Publication 59-60 Reasonable Compensation Job Aid lists a number of factors that are considered in the determination of reasonableness:
the employee’s background and experience; the employee’s qualifications; the amounts paid by similar size businesses in the same area to equally qualified employees for similar services; the salary policy of the taxpayer as to all employees.
Extraordinary times such as our current times calls for extraordinary measures. Maybe you have enough assets or other income sources to weather the storm of a reduction in revenues. If you do, you may be considering cutting your salary, and you may be thinking, “But isn’t this whole post about needing to pay myself a reasonable compensation.” You are absolutely correct in thinking that. Let’s go back to Joe and some of the other comments in the previous section. If reasonable compensation is the amount that would normally be paid for like services, wouldn’t Joe continue to collect a $50,000 salary working for a competitor. Right now maybe not, but let’s assume that economic times are normal and a downturn in business is only specific to Corp 1.
Looking at it through that lens, Joe should definitely still receive his $50,000 salary even if it means Corp 1 operates at a loss. A brief side note on a couple of reasons why you may not want to operate at a loss. A loss will reduce the shareholder’s basis which could impact the amount of allowable future losses, and a lower basis means a bigger gain when selling a business. Also, a loss might scare potential buyers away (future blog post). I digress.
Armed with that knowledge, you may decide it’s best to not operate at a loss and the only option is to cut your salary and make up your reduced salary in a future year. According to IRS Publication 59-60 Reasonable Compensation Job Aid, you would be within your right to do so if you can meet three requirements:
1. Taxpayer must establish the fact of the prior under-compensation
2. There must be a record of the contemporaneous intent to compensate for under-compensation in future years.
3. The specific amount of the identified under-compensation must be stated.
In Perlmutter, 44 T.C. 382 (1965), the taxpayer argued that compensation in a later year was high because they were making up for the fact that he did not take a salary in the corporation’s first fiscal year. The court pointed out that “the corporation’s minute book was kept on a very informal basis and did not record all corporate actions.” While the court acknowledged there was a corporate resolution establishing the taxpayer’s salary for two of the years in question recorded in the minute book, there was no evidence of the increased salary due to an under-compensation in a prior year. While this case involves a C Corporation, it is good practice for any business to document salary adjustments.
The IRS guidelines for Reasonable Compensation put it like this, “the amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly.” Notice the language. It states amounts received, not profits. Let’s go back to Joe. Joe is on track to have a down year. He is still projected to have profits, but his net income is expected to drop to $75,000. He would still have enough to pay his reasonable comp and take a smaller distribution. However, the down year is scaring Joe, and he wants to leave a little more liquidity in Corp 1 to weather any possible storm coming. So, he decides to forgo his salary. According to the Reasonable Compensation IRS Guidelines, “S Corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.” Another way to look at this is if Joe does not take any distributions, he does not have to pay reasonable comp. Distributions trigger the need for reasonable comp.
Reasonable compensation is a double-edged sword. It allows shareholder employees to have some profits free of payroll taxes, but it requires a fair and reasonable payment to a shareholder. At the same time, you do not have to overcompensate yourself out of fear of running afoul of these standards. Consider having a reasonable compensation study done every few years and memorialize any salary adjustments in your corporate minutes along with supporting documentation.