News & Events
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July 2010
Wage Compensation Of S Corporation Officers
by Jack S. Johal
The IRS has provided useful information for S corporations and their owners concerning the proper tax treatment when corporate officers perform services for the Corporation. Specifically, it explains the proper employment tax treatment of payments made to S corporation officers and how 2% shareholder-employees treat company-paid health insurance premiums. Background. S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. S corporation shareholders report the corporation's income and losses on their personal tax returns and are assessed tax at their individual income tax rates. The Internal Revenue Code ("Code") states that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes.
S corporations should not to attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. An officer who is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/ shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, payment are employees whose compensation is subject to federal employment taxes.
While corporate officers are generally treated as employees for employment tax purposes, there is an exception that provides that an: (i) officer who does not perform any services or performs only minor services in his capacity as an officer; and (ii) who neither receives nor is entitled to receive any remuneration directly or indirectly, is not an employee.
Reasonable Salary
The instructions to Form 1120S, U.S. Income Tax Return for an S corporation, states "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." The amount of the compensation can not exceed the amount received by the shareholder either directly or indirectly; however, the salary must be determined and the level of salary must be reasonable and appropriate. There are no specific guidelines for reasonable compensation. Courts ruled that the issue of reasonable compensation is based on the facts and circumstances of each case.
Factors that courts have considered in determining reasonable compensation, include, without limitation:
- training and experience;
- duties and responsibilities;
- time and effort devoted to the business;
- dividend history;
- payments to non-shareholder employees;
- timing and manner of paying bonuses to key people;
- what comparable businesses pay for similar services;
- compensation agreements; and
- use of a formula to determine compensation.
Medical Insurance Premiums
Health and accident insurance premiums paid on behalf of a 2% S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee's Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but is not included in Boxes 3 or 5 of Form W-2.
A "2% shareholder" is any person who owns (or is considered as owning under the constructive ownership rules) on any day during the S corporation's tax year more than 2% of the outstanding stock of the corporation or stock possessing more than 2% of the total combined voting power of all stock of the corporation.
A 2% shareholder-employee is eligible for an adjusted gross income deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation. At one time, "established by the S corporation" meant that the medical care coverage had to be in the name of the S corporation. The IRS has ruled, however, that if the medical coverage plan is in the name of the 2% shareholder and not in the S corporation's name, a medical care plan can be considered to be established by the S corporation if it either paid or reimbursed the 2% shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2% shareholder's Form W-2.
Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of Form W-2. Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.
Please if you have any additional questions.
