The IRS is auditing a number of S corporation including compensation issues.
S corporations must pay reasonable compensation to share holder employees in return for services before non-wage distributions may be made.Wages are subject to FICA, FUTA and federal income tax withholding, while non-wage distributions are not. Officers are employees, and the fact they are also a shareholder does not change this. An officer not performing any services or only minor services and who is not entitled to compensation is not considered an employee. Several court cases support IRS authority to reclassify other forms of payments to a shareholder-employee as wages subject to employment taxes. Factors in determining reasonable compensation:
- 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
- The use of a formula to determine compensation
- Treating Medical Insurance Premiums as Wages
Heath and accident insurance premiums paid on behalf of 2% or greater share holder employees are deductible and reportable by the S corporation as wages for income tax withholding purposes on the shareholder-employee’s Form W-2, but are not subject to Social Security or Medicare (FICA), or Unemployment (FUTA) taxes. The additional compensation is included in Box 1 (Wages) of the Form W-2, but not in Boxes 3 and 5. A 2% or greater share holder employee is eligible for an Adjusted Gross Income (AGI) deduction (“above-the-line”) for amounts paid during the year for medical care premiums if the medical care coverage is paid by the S corporation and included in the shareholder’sW-2, and the shareholder meets the other self-employed medical insurance deduction requirements (but not if the shareholder’s spouse is eligible to participate in any subsidized health care).
Shareholders are responsible for tracking their stock and debt basis, which goes up and down based on the S corporation’s operations. A shareholder cannot claim losses and deductions in excess of stock and debt basis. S corporations issue Schedule K-1 to shareholders reflecting the shareholder’s allocable share (pro rata by stock ownership) of S corporation’s income, loss and deductions. The K-1 does not state the taxable amount of the distribution, which is contingent on the shareholder’s stock basis.
Shareholders must have adequate stock and/or debt basis, and also meet at-risk limitations and passive activity limitations to claim a loss and/or deduction. Stock basis begins with initial capital contributed or the initial cost of the stock purchased (the same as a C corporation), increased and/or decreased based on the flow through amounts – income items increase stock basis, and losses, deductions and distributions decrease stock basis. Stock basis is adjusted annually in the following order as of the last day of the S corporation year:
- Increased for income items and excess depletion;
- Decreased for distributions;
- Decreased for non-deductible, non-capital expenses and depletion; and
- Decreased for items of loss and deduction.
Debt basis is computed similarly to stock basis with some differences. A shareholder is only allowed debt basis to the extent they personally lent money to the S corporation. A loan guarantee is not sufficient to allow the shareholder debt basis. If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment may be taxable to the shareholder.
Non-deductible expenses reduce a shareholder’s stock and debt basis before loss and deduction items. Non-deductible expenses in excess of basis are not carried forward. If the current year has different types of losses and deductions exceeding stock and debt basis, allowable losses and deductions must be allocated pro rata.
If an S corporation operated as a C corporation before making the S election, and has C corporation earnings and profits (E&P), distributions are non-taxable to the extent of the accumulated adjustments account (AAA), and then a dividend to the extent of E&P. The AAA tracks S corporation income taxed to a shareholder but not distributed, so that the income is only taxed once and not a second time when later distributed. Otherwise, non-dividend S Corporation distributions are tax-free to the extent of shareholder’s AAA and then stock basis (debt basis is not considered). Non-dividend distributions exceeding stock basis are taxed as a capital gain, usually a long-term capital gain (LTCG).
Losses and deductions not allowable in the current year due to basis limitations are suspended and carried forward indefinitely until basis is increased in subsequent years, or the shareholder disposes of the stock. Suspended losses or deductions retain their character.
Current year loss and deduction items are combined with the suspended losses and deductions carried over from the prior year, but should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return.
If stock is sold, suspended losses due to basis limitations are lost. The sales price does not have an impact on the stock basis. Stock basis should be reviewed in the year stock is sold or disposed of.