TAXATION OF S CORPORATION SHAREHOLDER
INCOME – THE DILEMMA OF DETERMINING REASONABLE COMPENSATION
In the 110th Congress, Ways and Means Chairman Charles
Rangel (D-NY) has introduced legislation, H.R. 3970, to repeal the
individual Alternative Minimum Tax and cut the top corporate tax rate.
One of the revenue offsets in the bill is a provision to require
shareholders of S Corporations that primarily provide services to include
almost any type of distribution from the corporation as income for the
purpose of calculating self employment tax liability.
An S corporation is a corporation
that does not pay an entity-level tax such as the corporate income tax.
Instead, the profits (or loss) are passed on to the shareholders, who must
account for them separately on their individual income tax returns. This
occurs even if the S corporation retains its earnings, rather than
distributing them to shareholders.
In order to qualify as an S
corporation, a firm must be a domestic corporation with no more than 100
qualified shareholders and no more than one class of stock. To become an
S corporation, a qualifying corporation shareholders all must sign a Form
2553 (Election by a Small Business Corporation). A corporation can lose
its S status by failing to continue to meet all the criteria for a small
business corporation, or by having excess passive investment income and
accumulated earnings and profits at the end of the year for three
consecutive tax years. Once a firm loses its S status, it (or any
successor) must wait five years before it can elect that status again.
In dealing with S Corporations, one
of the larger concerns, from a tax collection perspective, is whether S
corporations sufficiently compensate their owner-employees. Government
officials have increasingly become interested in whether an entity is
underpaying the salaries and wages of the shareholders in order to
minimize tax liabilities, particular “employment taxes.”
Two government entities have
released studies in recent years that have questioned whether the current
system of taxation for S corporations is allowing these entities and their
owners to avoid paying their fair share of taxes.
Treasury Inspector General for Tax Administration Report
In 2002, the Treasury Inspector
General for Tax Administration (TIGTA) reported that the Internal Revenue
Service (IRS) needed more effective means of identifying taxpayers who are
not properly reporting Subchapter S corporation officer compensation. The
report looked at the incentive to underpay salaries and wages in order to
avoid paying FICA and Medicare taxes.
S corporations were originally
established by Congress under the Technical Amendments Act of 1958.
However, as the law did not set the employment tax treatment of corporate
profits, a year later, the IRS issued a ruling that created guidelines for
taxation of S corporations. The ruling was issued under the assumption
that S corporations would have multiple shareholders and owners. Over the
years, it has become clear that the large majority of S corporations are
owned by a single shareholder. The IRS estimates that in 2003 that there
were approximately 3.2 million S corporations in the United States.
According to TIGTA, in Tax Year
2000, 69.4 percent of all S corporations were fully owned by a single
shareholder, while another 9.5 percent had a single shareholder who owned
more than 50 percent of the shares. As a result, nearly 80 percent of S
corporations had a single shareholder deciding what to pay him or herself.
The report discovered that S corporations reported an average of $5,300 in
wages on their 1120-S Forms, while reporting an average of $349,323 in
distribution on their schedules M-2.
As a result of these findings, TIGTA
made four recommendations. First, additional technical guidance should be
provided to IRS field personnel in determining what qualifies as
reasonable officer compensation. Second, those corporate distributions
not presently captured from filed S corporation tax returns should be
inputted into the IRS's computer system during returns processing. Third,
that a request for information services to identify officer
compensation-related adjustment assessments made to S corporation
employment tax accounts should be submitted. Finally, TIGTA recommended
that educational outreach activities should be expanded.
On May 25, 2005, the Senate Finance
Committee held a hearing to discuss the solvency of Social Security. Two
of the witnesses who were invited largely talked about the issue in
regards to the tax gap; that is, they spoke on how Social Security and
Medicare were being short-changed due to loopholes in the tax code.
George K. Yin, the Chief of Staff of
the Joint Committee on Taxation (JCT), spoke about the recommendations the
JCT made in its report on the tax gap released earlier that year. J.
Russell George, the Inspector General of TIGTA also testified. His
testimony coincided with a report issued by his office the same day,
regarding the taxation of S corporations.
The report asserts that the current
system of taxing S corporations presents a significant loophole that
allows single-shareholders to avoid certain taxes. As an example, TIGTA
demonstrates that in 2000, the owners of 36,000 single-shareholder
corporations received no salaries from their corporations, even though the
operating profits exceeded $100,000, resulting in unpaid employment taxes
of $13.2 billion. As a result, the report concludes that the IRS, by not
attending to this issue, leaves a significant amount of tax revenue
In addition to their earlier
proposals, TIGTA recommended that all net income from S corporations that
are more than 50 percent owned by a single shareholder should be subject
to payroll taxes. TIGTA estimates that this action would result in a
nearly 80 percent tax increase for S corporations.
Joint Committee on Taxation
In the last Congress, at the request
of then Senate Finance Chairman Charles Grassley (R-IA) and Ranking Member
Max Baucus (D-MT), the Joint Committee on Taxation (JCT) issued a report
on January 27, 2005 entitled “Options to Improve Tax Compliance and Reform
Tax Expenditures.” As stated in its introduction, the report was designed
to “present various options to improve tax compliance and reform tax
The JCT report discovered that,
together with partnerships, estate, and trust net income, S corporations
contribute between $16 and $24 billion to the tax gap.
The report suggested that Congress
extend the application of payroll taxes to owners of “pass-through”
entities such as S corporations, thereby subjecting all of the net
earnings of these businesses to the payroll tax, whether or not these
earnings are distributed to the owners of the firm.
The report included a recommendation
to treat S corporations in a manner similar to partnerships, and
shareholders of S corporations like general partners. The result would be
that S corporation shareholders, who materially participate in the
business, would be subject to self-employment tax on their shares of S
corporation net income. Exceptions would be allowed for certain rental
income, dividends and interest, certain gains, and other items. In the
case of a service business, all of the shareholder’s net income from the S
corporation is treated as net earnings from self-employment. In a
personal service S corporation substantially all of its activities involve
the performance of services in the fields of health, law, engineering,
architecture, accounting, actuarial science, performing arts, or
On May 25, 2005, Mr. Yin, the Chief
of Staff for the JCT, testified that the Committee has found that “it has
become increasingly common for individuals who perform services in
businesses that they own to choose the S corporation form to seek to
reduce their FICA taxes.” The shareholders pay themselves a nominal wage
while treating the rest of their compensation as a distribution.
Mr. Yin restated JCT’s view that all
partners should be subject to self-employment tax on their distributive
share of partnership income or loss, even if the distributive share is not
distributed. The proposal would treat S corporations as partnerships and
the shareholders as general partners, for purposes of the employment tax.
The JCT estimated that, through their proposals, the federal government
could raise an additional $57 billion over the next 10 years.
S corporations were originally
created in order to allow small and family-owned businesses to avoid
double taxation. Prior to the 1958 law, entrepreneurs could either choose
to be a regular C corporation or a partnership. By choosing the former,
they would benefit from liability protection but face double taxation at
the federal level (both corporate and individual). By choosing the
latter, they would only be taxed once (individual) but sacrifice liability
protection. At the suggestion of the Treasury Department, President
Dwight Eisenhower promoted legislation that would create S corporations.
The underlying debate behind both
the TIGTA and JCT proposals is how shareholders of an S corporation should
determine what portion of their income should be characterized as wages
and what portion should be characterized as profit. Historically, the IRS
and the courts have struggled with how to determine “reasonable
compensation” for owner-employees. According to the IRS audit manual, the
IRS uses such factors as: “nature of duties, background and experience,
knowledge of the business, size of the business, individual's contribution
to profit making, time devoted, economic conditions in general, and
locally, character and amount of responsibility, time of year compensation
is determined, whether alleged compensation is in reality, in whole or in
part, payment for a business or assets acquired, the amount paid by
similar size businesses in the same area to equally qualified employees
for similar services, etc.”
However, over the years, the courts
have also weighed in on the subject of reasonable compensation. In cases
involving S corporation payments to a shareholder-employee, courts have
re-characterized a portion of the distributions as wages when the
individual performing a service does not include any of the income as
Recently, courts have applied a
multi-factor test to determine reasonable compensation. Most notably,
they have considered whether an individual's compensation was comparable
to compensation paid at similar firms. Going further, the Seventh Circuit
adopted an "independent investor" analysis, which asks whether an
inactive, independent investor would be willing to compensate the employee
as he was compensated. The independent investor test has been examined
and partially adopted in some other Circuits, changing the analysis under
the multi-factor test.
The proposals offered by the JCT and
TIGTA essentially take out any guesswork in determining reasonable
compensation by assuming that all of the income should be considered
wages, reduced by certain excluded items. By applying payroll taxes to
all income, the government would levy a substantial tax increase on many
small and family-owned businesses.
The proposal would require a
shareholder of an S Corporation that primarily provides services to
include all distributions, regardless of the nature of the distribution
with some narrow exceptions, as income for the purposes of calculating
self-employment taxes. The bill does not define “services.”
As congressional leaders continue to
look for ways to address the budget deficit or provide tax relief,
particularly under the PAYGO regime, they are going to increasingly look
to the “tax gap” and other revenue offsets.
Whether or not it is accurate to
consider the issue of reasonable compensation as a tax gap issue, it is
likely only a matter of time before Congress look to the taxation of S
corporation shareholders income for needed revenue.
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