With tax reform on the horizon, Congress is looking into payroll tax reduction (or avoidance) that brings popularity to the S-Corporation status. After numerous court cases resulting in rulings favorable for the IRS about unreasonably low compensation, we may be seeing a change in tax law regarding S-Corporations.
For those that may be drawing a blank when it comes to S-Corporations, it is clearly defined by the IRS as “corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.” S-Corporations therefore avoid the so-called “double taxation” of dividends.
While this may seem easier for shareholders of S-Corporations, it also brings about a strong temptation to pay a lower salary and a higher profit distribution, because shareholder-employees receive both wages and profits from the S-Corporation.
According to the AICPA Insights article titled Another Lesson on Unreasonably Low Compensation, there have been several recent court cases dealing with business owners claiming lower wages to save the 7.65% FICA and Medicare taxes on those unreported wages. This is somewhat of a loophole in the tax system.
One example was Herbert v. Commissioner, where the primary issue was whether the $52,600 petitioner Patrick Herbert received in 2007 from a subchapter S-Corporation should be treated as additional wages subject to employment taxes. Herbert was found to have under-reported his wages due to not having a proper set of books and record keeping.
The IRS is fully aware of these scenarios and is actively seeking out S-Corporations paying out below-average wages. They have continually said that S-Corporations must pay their shareholder-employees a “reasonable compensation” for services.