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Tax Tips & Audit Strategies for S-Corporation Shareholders

Reasonable Compensation

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The number one audit risk for S-Corporations is salary and wages paid to officers of the corporation. S-Corporations are also subject to hobby-loss rules. Together these are the two most significant audit risks facing S-Corporations right now.

Reasonable Compensation

The fastest way to get audited as an S-Corporation is to file an 1120S with no amount showing on Form 1120S Line 7 "Compensation of Officers." It is assumed by the IRS that no one works for free, and so the IRS has said over and over again that officers of the corporation must receive wages (reported on line 7). As an owner-employee of the S-Corporation, you must pay yourself a salary, and pay payroll taxes on your salary, even if the business is losing money. You don't have to pay yourself a high salary, but it must be a "reasonable amount" according to the IRS. Reasonableness can be interpreted in different ways. I would keep track of the number of hours you work for your business, and then figure out a "reasonable" salary to pay yourself based on the amount of time you spend.

If your S-Corporation is losing money (especially in the first few years of operation), then your losses will be exaggerated by the salary you have to pay yourself. Thus, if your economic losses (not counting your salary) is $10,000, but you need to pay yourself a "reasonable" salary of $10,000, then your tax loss will be at least $20,765 ($10,000 economic loss + $10,000 salary + $765 in employer-paid payroll taxes). In an S-Corp, your tax losses will always be greater than your economic losses, and your tax profits will always be less than your economic profits.

What's a Reasonable Salary?

Compensation of shareholder-employees should be based on the same criteria as salary for non-shareholders. Factors would include prevailing market rates; the individual's knowledge, skills, and abilities; amount of hours worked; and so forth. Salary is reasonable if a non-shareholder would be willing to accept the job at the proposed salary level.

Generally, the IRS will grant the S-Corporation a degree of latitude in setting salary compensation for shareholder-employees. However, the salary must be paid, and the level of salary must be appropriate.

What's an Unreasonable Salary?

Zero salary is unreasonable. No one works for free.

Salary below minimum wage is unreasonable. You would not persuade a non-shareholder to accept a job offering below minimum wage.

Salary far in excess of an appropriate wage is unreasonable. Paying a million-dollar salary when an officer in similar position would expect to make only $150,000 is also unreasonable. Some S-Corporations have attempted to pay higher-than-normal salaries as a way to increase business expenses.

Why is Officer Compensation an Audit Priority?

The IRS can collect payroll taxes on officer compensation, and the penalty for failing to pay payroll taxes is 100% of the taxes owed. S-Corporations will avoid this payroll tax penalty by paying shareholder-employees a reasonable compensation.

Hobby-Loss Rules

An S Corporation is presumed to be a for-profit enterprise if it shows positive net income in three years out of a five year period. Typically, that means an S Corporation should try to plan on having at most two loss years in any five-year period. Nonetheless, S corporations might be able to prove they have a profit motive even though they have more than 2 years of losses if they can show increasing sales, maintain expenses, and project a profit in the near future.
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