IRS TARGETS OWNER’S COMPENSATION IN S CORPORATIONS

By Steve Barlotta, CPA

Over the past few years, I have cautioned my S Corporation clients that the IRS are clamping down on owners that take a minimum salary. In fact, last year the IRS won a case in U.S. district court against a CPA, of all people, in Iowa who they determined received a salary that was exceedingly too low.

You might ask: “What’s the big deal, an owner should be able to determine his level of compensation?” Unfortunately, the IRS doesn’t see it this way; particularly with S Corporations. In an S Corporation, distributed profit is not subject to FICA taxes. Whereas, all salary is subject to a 2.9% Medicare tax and some is subject to a 12.4% Social Security tax (Social Security income cap for 2012 is $110,100). By reporting lower compensation on their W-2s, S Corporation owners aren’t saving on income taxes, but are saving on the FICA payroll taxes that would have to be paid. In the court case referred to above, the IRS determined that the taxpayer saved nearly $20,000 in payroll taxes for two years. In cases like these, the IRS is also assessing penalties and interest in addition to the extra tax.

As they search for more revenue areas, I believe the IRS will focus more heavily on S Corporation compensation. Obviously the agency keeps statistics on things like owner salaries. From 1995 to 2007, S Corporation income doubled while salaries increased by only 26%. According to Martin Sullivan from Tax Analysts, the recent average compensation for S Corporation owners was only $38,000. It’s fair to assume that the IRS sees the disconnect here and will look to target S Corporations for increased audits.

What should an S Corporation owner do going forward? Well, to the best of my knowledge, the IRS doesn’t issue any guidelines as to what constitutes reasonable compensation. The best piece of advice that I can offer to an owner is to keep their pay in line with the personal services that their providing to their corporation. If they have access to industry information, an owner might want to find out the average percentage of compensation to total sales. As this subject will continue to be a hot-button issue with the IRS, I believe it will be very important for S Corporation owners to exercise professional judgement and caution when determining their compensation.

Source: Laura Saunders, “The IRS Targets Income Tricks”, Wall Street Journal, January 22, 2011.