S corporation required to pay reasonable compensation.
S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “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.”
Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment tax.
The three major sources are:
- Services of shareholder,
- Services of non-shareholder employees, or
- Capital and equipment.
If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee’s personal services and it is reasonable that the shareholder would receive distributions along with compensations.
On the other hand, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation.
In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.
Some 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
The Affordable Care Act (ACA) did not change the above rules regarding the federal tax treatment of health and accident premiums paid for a 2% shareholder.
However, for tax years after 2013, the ACA imposes penalties on the S corporation if the S corporation offers a health plan that fails to comply with certain market reform provisions, which may include plans under which the S corporation reimburses employees for the cost of individual health insurance premiums. The potential excise tax is $100 per day, per employee, per violation.
Among the ACA market reform provisions is a requirement that a group health plan must not impose annual limits on essential health benefits. In Notice 2013-54, the IRS indicated that a health plan under which an employer reimburses employees for the cost of individual health insurance premiums (referred to as an “employer payment plan”) will generally be treated as failing this requirement because the employer payment plan is treated as imposing a limit up to the cost of the individual policy premium.
The excise tax for failure to satisfy the ACA market reforms generally will not be imposed on an S corporation in the following two situations:
- The S corporation provides medical benefits under a health plan that satisfies the ACA market reform requirements(for example, a group health plan that does not provide for reimbursement of individual policy premiums); or
- No more than one active employee participates in the employer payment plan under which the S corporation reimburses the cost of individual policy premiums.
The ACA market reform provisions do not apply to plans that cover fewer than two participants who are active employees. IRC § 9831(a)(2).
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