Issues with Low S-Corp Shareholder Compensation

There is no black & white, definitive line, and that there are several factors to consider, that may be unique to the particular activity of a tax year when considering reasonable compensation of a s-corp shareholder employee. A previous post helps provide information to consider when setting the amount, this post specifically addresses why one wouldn’t want to set the amount too low when the s-corp shareholder employee provides personal services to the corporation.
In a recent discussion with a CPA, he cited some recent C.P.E. that he attended where attorneys were discussing the issue and what seemed to be currently accepted, and stressed the corporate veil to be in place through the corporate formalities of proper documentation of certain events. We agreed that corporate formality is very important to obtain the corporate benefits.
However, our positions started diverging from there. The “function over form” rule as been in long standing effect, which essentially means that it doesn’t make a difference how much paper you have to define something, if its inherent form requires different treatment that different treatment applies.
In my research, in small S-corps, where shareholders personally and predominately provide services that represent the majority of the corp’s revenue, the IRS considers most of what could be profit distribution as shareholder compensation.
Given their clearly published position, I suggest a more conservative approach to avoid distribution reclassification as wages and it’s associated problems. If there is a reclassification, it has a cascading affect:
1. Payroll taxes are due on the reclassification (that would have to be paid originally).
2. The associated penalties and interest on the now late payment on the payroll taxes.
3. Other penalties such as accuracy penalty may apply.
4. Since the reclassification changes the net income of the corp and shareholder wages, the amendments to the personal tax return (due to Sch K-1 and W-2 changes) will most likely result in additional taxes, penalties, and interest.
5. Shareholder Basis re-calculations need to be made and negative tax consequences in subsequent years (beyond the year being audited) that have already been filed (because audits take a couple of years to happen) may bubble up nullifying prior year tax planning meant to avoid them, and require amendments to those years possibly resulting in additional tax, interest, and penalties.
6. Additional CPA and/or accountant charges to represent client in that matter because audit representation is most typically not included in tax preparation fees unless H&R Block is preparing the return. 🙂
7. Additional accountant fees to amend associated returns, for example state corporate and payroll tax returns.
8. And, last, but certainly not least, while the IRS is “under the hood” examining that part of the corp return, the rest of the tax return will certainly be under review as well. Yep, in my recent experience representing clients in IRS audits, limiting the scope of the audit is extremely challenging, if not impossible these days…this used to be my very subtle expertise when I had my tax preparation practice. This causes more time and money to be spent with the expanded representation and possible additional taxes, interest, and penalties if there are changes.
In summary, my personal opinion is this: I don’t think being aggressive in this area is worth what may amount to up to a few thousand dollars of savings at the risk of greater cost if re-classed. It’s very easy for the IRS to determine this programmatically. I think that being conservative will serve clients best overall in the long run, especially since pass-thru entities are a published focus/target of audits by the IRS.
Certainly it’s the clients’ choice what to do, and what level of risk they are comfortable with taking. I have a responsibility to do my due diligence and help them make an informed decision as well.