We mostly stick to procedure on this blog. So we do not often talk about the taxation of entities. But most of us, even true procedure folks know that S corporations generally do not pay federal income tax on their profits. Instead, the profits flow through to shareholders and are not subject to self-employment taxes. This creates the incentive for shareholders to minimize or even fail to pay any compensation for service-providing S Corps. The savings for S Corps who fail to pay reasonable or in some cases any compensation means that there is a hefty amount of owed Social Security and Medicare taxes that the fisc misses out on (and I leave aside any 199A issues that create further incentives for S corps and their service performing shareholders to avoid or minimize salaries).
A recent TIGTA report highlights the problem. While IRS has made employment taxes a priority, TIGTA notes that IRS selects few S corporations for examination. On top of that, “when the IRS does examine S corporations, nearly half of the revenue agents do not evaluate officer’s compensation during the examination even when single-shareholder owners may not have reported officer’s compensation and may have taken tax-free distributions in lieu of compensation.”
This is bad news. The study looked at a few years of S Corp returns and noted that some really profitable S Corps with only one shareholder pay absolutely no compensation:
TIGTA’s analysis of all S corporation returns received between Processing Years 2016 through 2018 identified 266,095 returns with profits greater than $100,000, a single shareholder, and no officer’s compensation claimed that were not selected for a field examination. The analysis found that the single-shareholder owners had profits of $108 billion and took $69 billion in the form of a distribution, without reporting they received officer’s compensation for which they would have to pay Social Security and Medicare tax. TIGTA estimated 266,095 returns may not have reported nearly $25 billion in compensation and may have avoided paying approximately $3.3 billion in Federal Insurance Contributions Act tax.
As TIGTA notes, there are many cases that hold that shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends, or other forms of compensation instead of wages. The substantive rules require that S Corp shareholders performing services are to take reasonable salaries. For some of these cases, see Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001). Joly v. Commissioner, T.C. Memo. 1998-361, aff’d by unpub. Op., 211 F.3d 1269 (2002). Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 (2002). David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012).
Reasonable compensation cases have been around for many decades. It used to be that the reason for the cases was the flip side because solely owned companies wanted to pay a high salary in order to avoid the problem with dividends. So, companies with lots of assets would structure their compensation to the executives to avoid having any money left over for dividends and avoid the tax on leaving excess profits in the corporation.
To get to a court case is labor intensive, though for sure in any situation with zero compensation it would be fairly easy for the government to prove that there should be some deemed compensation. S Corp audits are handled in the field. For FY 2017-2019 there were about 5 million S corp returns filed. The audit coverage ranged from a high of 12,169 in FY 2017 to a low of 9,556 in FY 19, with coverage ranging from .2% to .3%. TIGTA notes that many of the audits failed to even raise the issue of officer compensation. While IRS should audit more and do a better job targeting the issue, I wonder if there needs to be a statutory fix that requires or perhaps presumes some minimum salary that is pegged to earnings. Any legislative fix should consider how to minimize the burdens both to the IRS and taxpayers and remove the temptation for businesses to play the lottery.
As Keith notes, there is a long-term cost to not paying a salary which is that the owner is not building Social Security credits. So, their social security upon retirement could be significantly less than it would have been otherwise if this goes on for a long time. While there is a back end savings to the government that may not be reflected in the loss figures that may be much less than the costs to the government relating to the foregone employment taxes.
About Leslie Book
Great article. We also saw that many owner/SHs were not eligible for the Paycheck Protection Program loans because did not have any W2 wages. That was needed to qualify for PPP. I agree, owner/SHs not taking wage compensation is commonplace.
Newt Gingrich and other politicians have used this technique, which might explain why the IRS has not clamped down on it. Also, the taxpayers involved in a Sub S/reasonable compensation audit typically have the resources to challenge the IRS, making these audits very resource intensive. With Congress cutting the IRS budget it makes sense that the IRS would favor less burdensome cases. Is there a pattern here, is Congress voting its own pocketbook?
These S Corporation owners are not preparing their own returns. There is a cottage industry of accountants who help small businesses reduce or eliminate their Social Security taxes. IRS, and now TIGTA choose to handle them with kid gloves. It would be politically unacceptable to require preparers to include a “due diligence” form with 1120-S returns, comparable to that required for a 1040 claiming even small amounts of Earned Income Credit, or Head of Household filing status. “Preparer Project” is always a threat in low-income neighborhoods. Don’t expect one here.
There is no line on the 1120-S to enter shareholder wages. There is a line, and sometimes a form for officer compensation, but this might also show up in “cost of goods sold.” (TIGTA claims this would be wrong, but they must not have read the instructions.) Meanwhile, owners can appoint as many non-shareholder employees as they want as officers, to pad the amount reported in that category.
As pointed out, many owners are reducing their eventual Social Security benefits by paying less employment tax. But the other side of that coin is that many can begin collecting Social Security sooner, before they reach “normal retirement age” of 66 plus, by keeping their W-2 income below the “earnings test” limit of about $19,000.
Yes, great post Les! I have seen this too, and to your last point, I also worry about those who are very much relying on social security as their retirement plan and don’t realize how this will impact the amount they receive in the future.
Easyish fix would be to treat S Corps like partnerships/LLCs, where self-employment tax is owed on non-passive trade or business profits. I think this has been proposed numerous times. Sad that it’s never been enacted.
Here is a thoughtful comment from a practitioner who wishes to remain anonymous:
I don’t think there is an easy fix because reasonable comp in that context depends on the nature of the business and the extent to which the personal services of the shareholder contribute to the profitability vs the use of capital (or even the leveraging of workforce, as in professional firms.) The real problem is the disparity between the LLC taxation where active income is subject to S/E tax and S corp gets to split it. The long failure to finalize SE tax regs has contributed to the problem.
It is a great example of poor case selection and allocation of resources by IRS. Having zero comp is indefensible and should be like shooting fish in a barrel for IRS and yet IRS wastes a lot of time with unproductive audits. In cases of zero comp, IRS should really be sending a compliance letter soliciting amended returns and following up with audit activity if returns are not amended. Good CPAs are advising clients to set a salary but there are a set of return preparers oblivious to this issue and taxpayers who do their own returns will typically miss the issue. Another example where IRS efforts at education could pay some real dividends. As you point out, it affects the taxpayer’s social security benefits.
Another drawback of taking minimal compensation from an S corporation is that disability insurance benefits based on compensation will also be minimal. I know of one CPA who was sued by his client, a truck driver finding out that his disability claim was for naught.