As an owner of an S-Corp, you must pay yourself reasonable compensation. S-Corp that pay their owners no salary or an unreasonably low salary will attract the IRS’s attention. This salary is subject to a self-employment tax of 15.3%, thus many taxpayers try to avoid or minimize employee compensation and maximize owner profits (which are not subject to self-employment).
An employee-owner of an S-Corp (Watson, 2012) paid himself $24,000 in salary while the S-Corp paid approximately $200,000 to the employee-owner as a distribution of equity. The court determined an annual reasonable compensation amount of $93,000 and reclassified some of the distributions as a salary. The corporation was ordered to pay penalties for unpaid employment taxes plus further penalties for negligence.
As an owner-shareholder-employee of an S-Corp, protect yourself by making sure to pay reasonable compensation that reflects the size and success of your business. Submitting your corporate tax return with unreasonably high or low officer compensation will easily catch the IRS's attention and could lead to an audit of your business. This reasonability test changes based on your industry and can fluctuate from as low as 30% up to as much as 50%; check with your tax and accounting professional to be sure you are taking the right amount.
An S-Corp is a ‘pass-through’ entity, meaning the net income of the company is passed through to the owner’s personal tax return. If you have losses from your S-Corp, you may use this to offset your taxable income. By law, the amount you may deduct as losses is limited by your basis in the company shares you own plus any outstanding loans you made directly to your corporation.
In this case law (Messina, 2017), owners of an S-Corp (Corp A) formed another S-Corp (Corp B). Corp A owned Q, a qualified subchapter S subsidiary. Corp B loaned funds to Q. The owners of Corp A claimed loan indebtedness to them in order to increase Corp A's indebtedness and consider its pass-through losses. This, for all intents and purposes, was them manipulating their balance sheet to avoid paying taxes due during that year.
The court determined that Corp B was formed in order to increase shareholders’ losses. To claim losses, S-Corp shareholder loans must run directly between the shareholder and the corporation. The taxpayers appealed this decision to the Ninth Court (Dec. 2019), but the final decision was made that the taxpayers had voluntarily formed Corp B to use the loan as an additional basis in Corp A.
The following tax case law relates to independent brokers and insurance agents who are trying to use an S-Corp to reduce their self-employment taxes.
Many financial advisors may recommend their customers to open an S-Corp and have their advisory fees paid to their S-Corp. This way their S-Corp earned the commission and it can partially pass through as a dividend which is not subject to self-employment tax. This situation does not apply to insurance agents and financial advisors as their commission should be paid directly to the individual or to a registered insurance brokerage firm. They cannot redirect commission payments to an S-Corp they own.
Ryan Fleischer (Fleischer, 2016) is a registered financial advisor and an insurance agent. As an independent contractor, he signed an agreement with both LPL to perform services as a financial advisor and with MassMutual to perform services as an insurance agent. Fleischer opened his own single-member S-Corp called Fleischer Wealth Plan (FWP). He entered into an employment agreement with FWP under which the company pays him a salary to perform duties in the capacity of Financial Advisor. Both LPL and MassMutual reported Fleischer’s commission on 1099’s issued to Fleischer himself. The commission he got from LPL and MassMutual was reported as an income of his S-Corp and was not reported on his personal schedule C. If Fleischer had reported his income on his Schedule C, it would be subject to self-employment tax. Shifting the commission to an S-Corp results in reduced self-employment tax.
What went wrong in Fleischer’s case? Income should be taxed to the person who earned it. LPL and MassMutual were contracted with Fleischer in person, not with FWP. Therefore, FWP could not claim this income and it should have been reported on Fleischer’s Schedule C.
What do all these cases tell us? As great as the S-Corp structure is for individual taxpayers to alleviate their taxable income, they come with greater responsibility to treat their business like an actual business. The common through-line in all the cases above is that the individuals in question in each case attempted to manipulate the structure of the S-Corp to gain a tax advantage without also adhering to the rules of running the S-Corp properly. These are fewer common pitfalls than co-mingling funds or failing to file the appropriate paperwork with state or federal governments, but they are no less important to be aware of when running your S-Corporation.