Owners Compensation

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The IRS has recently provided guidance regarding owner’s payroll for businesses filling as S-Corporations. This guidance impacts how much owner(s) should take as payroll, which is subject to Social Security and Medicare, and owner’s distributions, which is exempt from Social Security and Medicare.
 

In two tax-court cases (Label Graphics, Inc. v. Commissioner and Brewer Quality Homes, Inc. v. Commissioner), the courts have determined that owner’s payroll should be more nuanced than a simple percentage of profits. The court applied a mixture of the following criteria to determine if owner’s payroll was sufficient to justify the amount of owner’s distributions: 

• The employee’s role in the company.
• A comparison of the compensation  paid to similarly situated employees in similar companies.
•  The character and condition of the company.
•  Whether a relationship existed between the company and employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.
•  Whether the compensation was paid pursuant to a (1) structured, (2) formal, and (3) consistently applied program.
• The employee’s qualifications.
•  The nature, extent, and scope of the employee’s work.
•  Size and complexity of the company.
•  Comparison of the employee’s salary with the company’s gross and net income.
•  Prevailing general economic conditions.
•  Comparison of salaries with distributions to stockholders.
•  Compensation for comparable positions in comparable concerns.
•  Salary policy of the company as to all employees.
•  Amount of compensation paid to the employee in previous years.

The following steps should help your S-Corporation comply with the IRS’s interpretation of “Reasonable Compensation” for small business owners: 

1. At the beginning of the fiscal year, have a meeting of the shareholders (even if it’s just you!) where you identify what wage someone in your industry, geographic location, and position makes, and furnish that proof. While the IRS has not been explicit about what is accepted as proof of “Reasonable Compensation,” you may find websites such as salary.com or ziprecruiter.com helpful. Remember to keep a copy of this proof in your meeting minutes, be it digital, hard copy, or both.
2.  At that same meeting, identify if you anticipate your business will be able to support that wage and if it can’t, document why it cannot. Detail what pay arrangements the owner(s) will take should the business end up supporting “Reasonable Compensation” as the year progresses, as mentioned in step 1.
3. Throughout the year, do not take owner’s distributions until your business has paid its owners “Reasonable Compensation” covering the entire year.
4. After providing the “Reasonable Compensation” to the business owner(s), identify how much of the remaining profits the owner(s) are comfortable extracting as owner’s distributions.