S-Corporation Stockholders, Get IRS Tax Guidance
For private corporations and their employees, the IRS provides initial guidance on the new tax benefit for stock options and restricted stock units.
The Internal Revenue Service sent out Notice 2018-97 offering guidance on a recent tax law change. This change allows employees who qualify, from privately-held corporations, to defer paying income tax. This deferral is for up to five years and is on the value of stock options and restricted stock units (RSUs) granted to them by their employers.
The 2017 Tax Cuts and Jobs Act (TCJA) includes the tax law change. Here is the gist of it, executives, officers who receive high compensation and those owning 1% or more of the corporation’s stock cannot make the deferral election. Also, there is no deferral for FICA (Federal Insurance Contributions Act) tax and FUTA (Federal Unemployment Tax Act ) tax payable on the value of qualified stock.
Notice 2018-97, posted on IRS.gov, offers initial guidance taxpayers can rely on until the IRS issues future regulations. The IRS will address requests made by the public via comment, including the public issues regarding those regulations.
S Corporation Compensation Requirements
S corporation compensation requirements are misunderstood on many levels. Owner-shareholders often abuse it as well. An S corporation is a type of business structure in which the business does not pay income tax at the corporate level. Instead, the S-corp distributes the income, gains, losses, and deductions to the shareholders for to include as part of their income on the tax returns. This is also known as pass through, and are, thereforeare gains, these distributions are a return on investment and therefore are not subject to self-employment taxes.
Stockholders Who Work in the S-Corp
Take note, when the stockholders, who work in the business, should take reasonable compensation for their services in the form of wages. Of course, wages are subject to FICA (Social Security and Medicare) and other payroll taxes. This is where some owner-shareholders make the mistake. They do not pay themselves a reasonable compensation for the services they provide. Now, it is fair to say that some make this mistake because they are not aware of the IRS requirements. Sadly, some do this on purpose just to avoid the payroll taxes. For those who just read this post, you are now responsible for what you know.
IRS Code for Corporate Officers
The Internal Revenue Code is very clear, for federal employment tax purposes, that any officer of a corporation, is an employee of the corporation. This includes S-corps. S-corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. This is a BIG NO NO!
What Happens to Working S Corp Stockholders Who Do Not Receive Reasonable Compensation?
Here is more Internal Revenue Service tax guidance for stockholders. For the S corp that does not pay its working stockholders a reasonable compensation for their services, take note. This entity should understand that the IRS generally will treat a portion of the S corporation’s distributions as wages and impose Social Security taxes on the wages in question.
How does an S-Corp Determine Reasonable Compensation?
There is no specific method for determining what constitutes reasonable compensation. The basis are facts and circumstances regarding the compensation. Generally, it is an amount that unrelated employers would pay for comparable services under similar circumstances. Also, the basis and based upon the cost of living in the area where the business is located. The following are just some of the many factors that would be taken into account in making this determination:
- 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 servicesCompensation agreements
- The use of a formula to determine compensation
The problem here, of course, is that it is easy for the IRS to list contributing factors used by the courts in determining reasonable compensation and leave it to the corporation to quantify these factors into a reasonable salary but still have the ability to challenge the selected amount later if an auditor, off the top of their head, decides the compensation is unreasonable.
The IRS has a long history of examining S corporation tax returns to ensure that reasonable compensation is being paid, particularly if no compensation is shown being paid to employee-stockholders.
Reasonable Compensation in the IRS Spotlight
With the passage of tax reform, reasonable compensation will be in the spotlight because of the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will figure intro the shareholder’s income tax return. The QBI for the stockholder of an S-corporation is the amount of net income, as a pass-through to the stockholder, and on the K-1 is a QBI. However, the stockholder shall not include the reasonable compensation (wages) he or she was paid as QBI. Thus, wages paid to stockholders actually reduce the QBI because the S corporation deducts the wages as a business expense, therefore reducing the corporation’s net income and QBI. But that does not mean wages can be arbitrarily adjusted to maximize the Sec. 199A deduction.
IRC Sec. 199A Deduction
Here are some details about how the 199A deduction works and the impact of the reasonable compensation wages on the Sec. 199A deduction.
- The S corporation’s employee-stockholder’s wages are NOT included in qualified business income (QBI) when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and thus the smaller the 199A deduction, which is 20% of QBI. In this case, an S corporation would tend to pay the stockholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
- If married taxpayers filing a joint return have taxable income that exceeds $315,000 ($157,500 for other filing statuses), the 199A deduction begins to be subject to a wage limitation. Also, once the taxable income for married taxpayers filing a joint return exceeds $415,000 ($207,500 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. Therefore, these high-income taxpayers, an S corporation will pay stockholders less wage income for them to benefit from the Sec. 199A deduction.
- When an S corporation is a specific service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between $315,000 and $415,000 (between $157,500 and $207,500 for other filing statuses). And although the wage limitation is used in computing the phase out, once the taxpayer’s taxable income exceeds $415,000 ($207,500 for other filing statuses), the taxpayer will receive no benefit from the wage limitation and therefore would again want to minimize their reasonable compensation to minimize FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services (for more information on what constitutes an SSTB, please call).
The Taxpayer Trap!
Of course, taxpayers cannot pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for taxpayers who do not consider the factors that relate to reasonable compensation. There are commercial firms that have the data necessary to determine reasonable compensation and specialize in doing so. These firms can be found by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.
Updates on this and other TCJA provisions can be found on the Tax Reform page of IRS.gov.
- S Corporation Compensation
- Reasonable Compensation
- Factors Determining Reasonableness
- In the Spotlight
- Sec. 199A Deduction
Do You Need More IRS Tax Guidance?
We know that IRS tax guidance is very important in light of tax reform., as well as understanding reasonable compensation. Do you want additional information relating to reasonable compensation? Please feel free to give our office a call. We are happy to share with you any IRS tax guidance that is available to us. Worthtax remains current on daily IRS notifications about tax changes and updates. You may even need help gathering the right documentation and finalizing some end of year issues. Give me, Alex Franch, BS EA, a call at 781.849.7200 or email us at email@example.com. Oh, and with tax season quickly approaching in a little over a month, we encourage you to be one of the first to set up your appointment today! We are also offering a variety of client discounts to save you money.
Alex Franch, BS EA
Alex is a Tax Specialist and Partner at Joseph Cahill & Associates / WorthTax. He has a diverse background including a Bachelor of Science from Boston College in Mathematics and extensive military service. Alex is an Enrolled Agent and has a decade of tax preparation experience. He is passionate about serving businesses with tax and financial planning.
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