Compensation must be reasonable, or all distributions could be challenged.
Sometimes, the IRS is like the little Dutch boy, sticking a finger in the dam to stop the flow of water. When it comes to the taxation of S corporation compensation, the dam has had quite a few leaks over the years, and considerable effort has been applied to keep the dam sound.
The main reason for these leaks, and the constant vigilance, has to do with the difference in taxation of compensation and S corporation distributions — compensation is subject to employment taxes and distributions are not.
Back in the early 1980s, S corporation owner compensation was typically low. The IRS looked at officer compensation in corporations, but that was mostly in C corporations, and the issue was that too much compensation had been taken, not too little. But the increase in the FICA wage base from $25,900 in 1980, to $127,200 in 2017, coupled with the elimination of the Medicare wage cap, gave rise to the benefits of S corporation distributions. A business owner could limit W-2 compensation to a small amount, and take the remainder of corporate income in the form of S corporation distributions, without paying payroll taxes on the distributions.
For example, Joe runs his insurance business as an S corporation. He has no employees and all corporate income is earned through his personal efforts. His net corporate income for the year is $100,000 and he pays himself a salary of $24,000, with the remaining $76,000 paid as S corporation distributions. He saves $11,628 in combined business and personal payroll taxes.
For many years, this scheme worked great, but then, the little Dutch boy started plugging the leaks. The IRS challenged officer compensation as being too low, and won in U.S. Tax Court. Now, compensation must be reasonable, or all of the S corporation distributions could be challenged as disguised compensation.
Recently, the little Dutch boy found another leak, and the Tax Court helped shore up the dam. The new leak involved a financial consultant named Ryan M. Fleischer. Fleischer formed an S corporation for his financial services activities and, based on the advice of his attorney and CPA, paid himself a salary. He also entered into contracts with Mass Mutual and LPL in his personal capacity as a broker, not as an officer of the S corporation. He assigned the income earned through these contracts to the corporation, and all of the financial services income was reported on the corporate tax return. These contracts generated significant income and were reported to Fleischer personally on a 1099.
The IRS audited Fleischer, disregarded the S corporation, and treated all commission income earned by Fleischer individually. The total tax underpayment due to this change was $41,563.
Fleischer took the adverse audit determination to Tax Court and lost.
The IRS has the ability to allocate income to the party who actually earns the income, and according to the Tax Court, there are two requirements that must be met:
“The individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense.
“There must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position.”
The IRS and the Tax Court both agreed the first prong of the test was met — Fleischer was an employee of the S corporation. The problem was with the second prong — the corporation had no contractual relationship with Mass Mutual or LPL, and therefore, the corporation did not have control of the income.
Many S corporation owners enter into contractual relationships, and due to licensing requirements or other considerations, enter into these contracts as individuals. With the advent of Fleischer v. Commissioner, care should be taken to ensure all payments for services are paid to the corporation, not the individual.
Fleischer v. Commissioner has given the IRS another avenue of attack to reallocate S corporation income from low-tax distributions to high-tax compensation. Care should be taken to make sure all income is paid to the corporate entity. The time for reallocation of 1099 income is as the contract is drafted, or the income is paid, not during the annual tax return preparation.
The little Dutch boy is vigilant in stopping leaks and the IRS now has another avenue of attack on S corporation distributions. Successful implementation of this tax strategy requires planning. Knowledge and care should be taken to ensure contracts are in the corporate name to avoid what could be a painful tax bill.
Pamela Schuneman, CPA, is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]