S Corp Officer Pay

Fact sheet explains wage compensation of S corporation officers Fact Sheet 2008-25

Mike Habib, EA

A recently released IRS fact sheet provides useful information for S corporations and their owners concerning the proper tax treatment when corporate officers perform services for the entity. Specifically, it explains the proper employment tax treatment of payments made to officers of S corporations 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 shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. (Code Sec. 1366)

The Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. See, e.g., Code Sec. 3121(d)(1), relating to Federal Insurance Contributions Act (FICA) taxes.

Warning in fact sheet. Fact Sheet 2008-25 warns S corporations 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. It goes on to stress that the fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. The fact sheet emphasizes that 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 (see, e.g., Nu-Look Design Inc v. Com., (2004, CA3) 93 AFTR 2d 2004-608 and Yeagle Drywall Co Inc v. Com., (2002, CA3) 90 AFTR 2d 2002-7744).

While corporate officers generally are treated as employees for employment tax purposes, there is an exception in regs. Under this exception, an officer who doesn’t perform any services or performs only minor services in his capacity as an officer, and who neither receives nor is entitled to receive any remuneration directly or indirectly, is not an employee. (Reg. § 31.3121(d)-1(b))

Reasonable salary. Fact Sheet 2008-25 notes that 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.”

The amount of the compensation can’t exceed the amount received by the shareholder either directly or indirectly. However, if the shareholder received cash or property or the right to receive cash and property, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or regs. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Fact Sheet 2008-25 lists these factors that courts have considered 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; and
  • use of a formula to determine compensation.

Medical insurance premiums. The 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.

For this purpose, a “2% shareholder” is any person who owns (or is considered as owning under the constructive ownership rules of Code Sec. 318) 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 such corporation. (Code Sec. 1372(b))

A 2% shareholder-employee is eligible for an AGI 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. However, in Notice 2008-1, 2008-2 IRB 251, IRS stated 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.

Observation: Without affirmatively saying so, Notice 2008-1 effectively repudiated guidance appearing in an article on IRS’s web site in 2006. That guidance had concluded that an S corporation’s sole shareholder-employee couldn’t buy health insurance in his own name and get the above-the-line deduction for the premium expense. Such a deduction is now possible if the above requirements are met.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the 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.

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