iStock_000015122897XSmallIn 2014, S Corporation returns greatly outnumbered both “regular” corporate returns and partnership returns. Perhaps one of the reasons that S Corporations continue to be so popular, particularly relative to partnerships, is the ability in some circumstances to limit or avoid the imposition of self-employment tax on corporation income that passes through to the individual shareholder. For 2014 the self-employment tax rate was 15.3%, with the elimination of the (larger) Social Security component on compensation over $117,000.

The S Corporation Approach to Self-Employment Tax

An individual partner in a partnership is generally subject to this 15.3% self-employment tax on the pro rata share of the partnership’s income passed through to them, subject to the limits described above. However, the rules under Subchapter S differ significantly. If an S Corporation shareholder provides services to the corporation – let’s call them an “owner-operator” – and is paid a salary, that compensation is subject to FICA tax (the equivalent of self-employment tax) as if the owner-operator were an employee of an unrelated corporation. Alternatively, the corporation could not pay the owner-operator a salary but instead simply distribute cash to the owner-operator on a pro rata basis. As a shareholder is already subject to income tax on his or her pro rata share of the corporation’s net income, whether distributed or not, this distribution would not be separately taxed and, more importantly, would not be subject to the 15.3% self-employment tax. Few S Corporation owner-operators would ever take even $1 as compensation if this would be the actual result.

The old saying “if it looks too good to be true, it isn’t” could not be more appropriate than in this context. The IRS has been very successful for a long time in re-characterizing as compensation the distribution of S Corporation income to owner-operators where no portion of the distribution was treated and taxed as compensation. These cases generally involved single-shareholder S Corporations, where the owner-operator was performing either all or the majority of the corporation’s services. The case law and IRS rulings have set forth a fairly clear standard: treating the S Corporation as having paid no compensation to owner-operators is likely to be deemed unreasonable.

Determining “Reasonableness”

Of course, it is the grey areas that often matter most. What about situations where the corporation and the owner-operator(s) do treat some portion of their pro-rata share of corporation income as compensation and the balance as a distribution? Is there a magic ratio of compensation-to-distribution that will keep the IRS at bay? Not really. The test for determining the proper treatment of S Corporation income as compensation or distribution is one of “reasonableness”. Reasonableness, like beauty, is in the eye of the beholder.

The IRS has provided a list of factors, found in Fact Sheet 2008-25 describing the reasonable compensation of S Corporation officer-shareholders who perform services to the corporation. These factors include:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation

A separate, although largely overlapping, set of factors was also developed in the case law deciding these less obvious questions. These factors were set forth by the 8th Circuit Court of Appeals (borrowing an approach earlier adopted by the 6th Circuit Court of Appeals) in the Charles Schneider & Co. v. C.I.R., 500 F.2d 148 (8th Cir. 1974). The Court described the factors as involving an analysis of:

  • Employee qualifications;
  • The nature, extent, and scope of the employee’s work;
  • The size and complexity of the business;
  • Prevailing general economic conditions;
  • The employee’s compensation as a percentage of gross and net income;
  • The employee-shareholder’s compensation compared with distributions to shareholders;
  • The employee-shareholder’s compensation compared with that to non-shareholder employees or paid in prior years;
  • Prevailing rates of compensation for comparable positions in comparable concerns; and
  • Comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.

As with any factor-based analysis, the question of “reasonableness” comes down to a case-by-case determination of the unique facts and circumstances of each particular corporation and the owner-operator’s relationship to it. In those circumstances where the resolution of the issue can offer the potential for significant self-employment tax savings, consultation with a tax professional is a necessary first step in ensuring owner-operators take a sound approach to reasonable compensation.