How the taxation of S corporation wages has changed in recent years Featured

8:00pm EDT June 25, 2010

S corporations generally do not pay federal income tax.  Instead, S corporation shareholders pay federal income tax on their share of the S corporation’s taxable income, whether or not the S corporation distributes such earnings.  

Currently, S corporation shareholders are not subject to employment taxes on their share of S corporation earnings. However, when a person receives compensation as an employee of an S corporation, in addition to being subject to income tax, those wages are subject to taxes for payroll, Social Security and Medicare.

For calendar year 2010, the first $106,800 of wages is subject to a combined employee and employer Social Security tax and Medicare tax at a rate of 12.4 percent and 2.9 percent, respectively. After the Health Care Reform Act of 2010 phases in during 2013, the employee portion of the Medicare tax increases by 0.9 percent on wages in excess of $200,000 for individual filers and $250,000 for joint filers.

The changes will result in an extra $9 in tax on every $1,000 earned over $106,800 of wages.

“This tax burden did not go unnoticed by taxpayers or by the IRS,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “Shareholders of closely held S corporations began to forego their salaries and instead drew all of their earnings as S corporation distributions, thereby avoiding employment taxes. Not surprisingly, the IRS objected to this treatment and soon began auditing closely held S corporations and assessing liabilities for underpaid employment taxes and related interests and penalties.”

Smart Business spoke with McGrail about how the taxation of S corporation wages has changed in recent years and what to watch out for in the future.

How can S corporation shareholders avoid IRS scrutiny?

An appropriate balance must be achieved between wages and distributions that minimizes a shareholder’s tax burden and the potential for IRS scrutiny. This balance is different for every S corporation and is a function of the nature of the business, the number of shareholders and numerous other factors. A properly arranged allocation can save thousands of dollars in employment taxes.

The following is a fairly typical example: Assume a professional services firm comprised of three principal shareholders and six other professional employees files returns as an S corporation and has $600,000 of earnings before considering shareholder salaries. If the shareholders ignore the value of their services, then there are no wages or related employment taxes. This type of shareholder compensation has led to the increased IRS scrutiny.

Upon audit, the IRS will likely argue that all $600,000 of the corporate earnings is the salary of the three shareholders. If each shareholder is assessed employment taxes as if the $200,000 ratable share of such earnings is wage compensation, the assessed employment taxes will total approximately $63,000 before the IRS adds penalties and interest to its assessment, which can often equal or exceed the assessed tax.

Instead of taking an all or nothing approach to employment taxes, assume that the shareholders proactively seek guidance as to the reasonable salary associated with managing the practice and the performance of professional services. If it is determined that a reasonable salary for each shareholder managing the practice and performing services is $100,000, the self-assessed employment taxes on such salaries would be approximately $48,000. While this is more employment tax incurred than ignoring the issue, it’s a $15,000 savings compared to the audit assessment and generally avoids penalty and interest.

Taxpayers may want to play the audit lottery and hope to get to the reasonable position on audit. However, in audit, this becomes a contentious uphill battle with the IRS, and audits are a very expensive proposition all around.

Is there any legislation before Congress concerning S corporations?

In large part due to the increased avoidance of employment taxes, Congress is looking to pass legislation that will do away with any reasonable allocation between wages and S corporation earnings. House Bill 4213 proposes to tax all earnings from select S corporations as self-employment income subject to self-employment tax. This would eliminate any planning with reasonable allocation arrangements.

The current proposal would apply to any S corporation that has, as a significant asset, the business reputation of three or fewer persons. For example, the earnings of a law firm owned by two attorneys who are also the only persons performing legal services on behalf of the firm would be completely subject to self-employment taxes whether paid as wages or distributed as S corporation earnings.

Standards such as significant assets and business reputation of three or fewer persons will inevitably require further guidance from Congress or the Treasury. If the legislation becomes law, it also will inevitably lead taxpayers to merge or add other employees to avoid the application of these new rules.

Are there advantages to the proposed legislation?

Early in the development of S corporations as a choice of business entity, shareholders attempted to include the earnings from the S corporations as self-employment income for purposes of funding their own qualified retirement plans.

The IRS ruled quickly on these attempts and concluded that because S corporation earnings were not subject to self-employment tax, they could not be considered as self-employment income for purposes of funding qualified retirement plans.

It remains to be seen how the new legislation will impact qualified retirement planning.

WALTER M. McGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or wmm@cendsel.com.