How you calculate your compensation can draw the eye of the IRS. Make sure you have clear justification — that's not based on paying the least amount of taxes.
Owner compensation is a hot button issue for the IRS and has a bit of a schizophrenic nature. Sometimes the IRS will argue that owners are being paid too much and sometimes too little. It all depends if the corporation is a C corporation or an S corporation because the taxation of these two entities is completely different.
A C corporation is a tax-paying entity. Most large corporations are C corporations and many professional service corporations, such as law firms or medical practices, are also taxed in this manner. A C corporation has two layers of taxation: once at the corporate level and again at the shareholder level. This double layer of taxation makes the income tax rate on earnings paid to shareholders very high.
To minimize taxes, many owners of C corporations will increase their wages, which decreases corporate earnings, and reduces double taxation.
If the corporation is eligible, an S election can be made, and the earnings of the business distributed to the shareholders. S corporations eliminate double taxation. In the past, many S corporation owners paid themselves minimal salaries and received the bulk of their income from corporate distributions. S corporation distributions are not considered earned income and therefore not subject to FICA or Medicare taxes.
Compensation is supposed to be “reasonable.” The amount paid should be what you would pay an unrelated third party to perform the specific services. For our purposes, assume a cardiologist makes on the average $375,000 a year. Dr. Lily, a prominent cardiologist, owns a professional corporation that earns $1 million before owner salary. If the corporation is taxed as a C corporation, the doctor would like to take a salary of $1 million, thereby eliminating corporate earnings and double taxation. Now if the corporation is taxed as an S corporation, the doctor would like to take a minimal salary, eliminate social security and Medicare taxes on earnings, with the remainder of income being taken as corporate distributions.
Now assume Dr. Lily is audited by the IRS. Here is what could happen if she maximized her tax savings under the two types of corporations.
C Corporation - Dr. Lily eliminated corporate profit by a year-end bonus that resulted in W-2 income to her of $1 million. The IRS asserts unreasonable compensation because the average cardiologist makes $375,000 a year and her salary of $1 million exceeds this amount. If she cannot justify her salary, the IRS will set her salary at the lower amount of $375,000 with the excess paid as a dividend. The corporation will now have taxable income of $625,000.
S Corporation - Dr. Lily decided to keep her salary low because she didn't want to pay social security or Medicare taxes. Her W-2 income was $50,000 and the remaining income was paid out as an S corporation distribution of $950,000. The IRS asserts unreasonable compensation, and because the income from the corporation is attributable to her personal services, it characterizes the $950,000 paid in distributions as additional compensation. Additional payroll taxes will be assessed along with steep penalties and interest.
Many closely held corporations have compensation practices that mirror the two prior examples and have no idea what they are doing could be a potential area of tax exposure.
Everything is great until the IRS assesses the tax and then slaps the unsuspecting taxpayer with large penalties and interest.
All corporations need to take proactive steps to support owner compensation amounts. The receipt of an IRS audit letter is not the time to take a look at the issue; by that time nothing can be done. Also, this is a very subjective area of the law. If the salary is set either too high or too low, the IRS will have an easy time making an adjustment.
To defend against unreasonable compensation attacks in audit, corporations should pay reasonable salaries and document how these salary levels are set.
In our examples, if Dr. Lily would have paid herself an amount close to $375,000, she would not be challenged by the IRS. If her corporation operates as a C corporation, she could probably come up with business reasons why her compensation should be more than the $375,000. These reasons should be documented in the corporate minutes and in most cases, the IRS will accept well thought out reasons for additional compensation. Likewise, if Dr. Lily's corporation is an S corporation, and her salary is somewhere close to $375,000, the IRS will not propose an adjustment.
In conclusion, the key to surviving an IRS unreasonable compensation challenge is to have adequate documentation that supports compensation amounts. The old adage “pigs get fat and hogs get slaughtered” is very relevant. If the IRS challenges, and salary amounts are not reasonable, you just may be bacon.
Pamela Schuneman, C.P.A., 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]