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Keeping Your Balance: S corporation shareholder compensation issues

John Finocchario

S corporations are often an attractive choice for a business entity because the earnings of the business are not subject to self-employment tax. It is important, however, to remember that shareholder-employees of an S corporation are entitled to receive compensation for the services performed for the corporation. This compensation must be treated as wages subject to federal employment tax. A variety of issues arise when an S corporation needs to compute the compensation paid to its shareholder-employees.

Reasonable compensation

When a shareholder performs more than minor services for the corporation, the corporation must pay that employee a reasonable amount of compensation before any non-wage distributions can be made to that shareholder.

The IRS has issued guidance in establishing reasonable compensation. In determining what services the shareholder performed for the corporation, an S corporation should consider whether the services resulted in a direct generation of gross receipts for the business.

If a significant amount of the gross receipts resulted from the services of the shareholder, then a large amount of the allocable profit should be treated as compensation to the shareholder rather than a distribution. The company should also determine whether any indirect administrative services were performed by the shareholder.

There are a variety of factors that the IRS may consider when determining reasonable compensation for a shareholder-employee. 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 compensations

Medical insurance premiums

Another issue that often arises relating to shareholder wages is the proper treatment of medical insurance premiums paid to a greater than two percent S corporation shareholder. If an S corporation pays medical insurance premiums on behalf of the shareholder, those payments should be treated as wages paid to the shareholder and would be subject to income tax withholding. The S corporation is then allowed to take a deduction for the amount paid.

A two percent shareholder may also be allowed a deduction against adjusted gross income on its personal income tax return for the amount of medical care premiums paid during the year. To qualify for the deduction, the medical care coverage must be established by the S corporation. For a plan to be considered established by the S corporation, the S corporation must have paid directly or reimbursed the shareholder for the premium payments, and reported those payments as wages on the shareholder’s Form W-2.

In addition, if the shareholder’s spouse is eligible to participate in any subsidized health care plan, then the shareholder is not entitled to the adjusted gross income deduction.

It is important to note that these benefits are not subject to Social Security, Medicare or Unemployment taxes. The payments are reported in Box 1, Wages, of Form W-2 but are not reported as Social Security or Medicare wages.

The IRS continues to target issues related to S corporation compensation of shareholder-employees. It is important that shareholders performing services for their S corporations be aware of the rules and factors relating to reasonable compensation.

Making a reasonable effort to determine an appropriate amount of shareholder wages will greatly diminish any risk of adjustment by the IRS in the case of an audit. S corporations should also be sure that they are properly reporting, as wages, any health insurance premiums paid on behalf of any two percent or greater shareholders.

John Finocchario, CPA, is a manager in the tax department at Mengel, Metzger, Barr & Co. LLP. He may be reached at