Smaller manufacturing companies often operate as
S corporations. In many cases, one of the shareholders (or perhaps the
only shareholder) also runs the business.
It's vital that S corporation owners who work in the business
pay themselves "reasonable compensation." If they don't, they may attract IRS
scrutiny — and possibly incur back taxes, interest and penalties. The
reasonableness of a shareholder-employee's compensation can also be an issue in
litigation, particularly when the business's value is in question.
Compensation vs. distributions
S corporation shareholders who perform services for the business
can receive both salaries for their services and distributions as shareholders.
Salary compensation is subject to both income and payroll taxes. A
distribution, on the other hand, can be taken tax-free, as long as it doesn't
exceed the shareholder's stock basis in the company.
Note:
Because an S corporation's income, gains, losses and deductions generally pass
through to the shareholders, who report the items on their individual tax
returns, shareholders pay tax on the business's income regardless of whether
they take distributions from it. But this pass-through income isn't subject to
payroll taxes.
If a distribution exceeds a shareholder's basis, the excess is
taxed at long-term capital gain rates (15% or 20%, depending on the
shareholder's income). And it's not subject to payroll taxes. Thus,
S corporation shareholders can potentially reduce their overall tax
liability by minimizing compensation and maximizing distributions.
However, the IRS requires S corporations to pay reasonable
compensation to shareholder-employees in exchange for services rendered before
making distributions. If the IRS finds that a shareholder-employee hasn't been
paid reasonable compensation, it may reclassify distributions as compensation —
which generally will result in the shareholder owing back payroll taxes,
interest and penalties.
IRS evaluation
From the IRS's perspective, the key to establishing reasonable
compensation for a shareholder-employee lies in determining the services
performed for the S corporation. To do so, the tax agency examines the
sources of the business's gross receipts. Were those receipts primarily driven
by the shareholder-employee's services, nonshareholder employees' services, or
capital and equipment?
To the extent gross receipts are generated by the services of
nonshareholder employees and capital or equipment, payments to the
shareholder-employee are properly treated as distributions free from payroll
taxes. Conversely, to the extent the shareholder-employee's personal services
generate gross receipts, payments to the shareholder-employee should be
classified as compensation. This bodes well for many S corporation owners
in the manufacturing industry, where capital, equipment and the efforts of the
nonshareholder workforce typically drive gross receipts much more than the
efforts of a single shareholder-employee.
That's not the end of the analysis, though. In addition to gross
receipts generated directly by the shareholder-employee, the IRS says the
shareholder-employee should be subject to compensation treatment for
administrative work performed for the other income-producing employees or
assets. The theory is that, while an owner may not directly produce gross
receipts, he or she nonetheless assists other employees or assets that produce
the day-to-day gross receipts.
So how do you determine reasonable compensation for an owner's
administrative and other work? Relevant factors include the:
- Owner's
training and experience,
- Owner's duties
and responsibilities,
- Time and
effort the owner devotes to the business,
- Company's
dividend history,
- Payments to
nonshareholder employees,
- Timing and
manner of paying bonuses to key people, and
- Compensation
that comparable manufacturing businesses pay for similar services.
It's not uncommon for the owner of a smaller manufacturing
company to wear several hats, of course. You might be CEO, CFO and CMO. Maybe
you handle sales, procurement and basic bookkeeping. Your compensation should
reflect all these responsibilities, not just the ones in your formal job
description.
Prepare now
If you fall onto the IRS's radar, you must demonstrate that your
salary is reasonable — and that your distributions aren't disguised
compensation. You'll need supporting documentation, including compensation
surveys from manufacturing trade associations, competitors' job listings and
data from the U.S. Bureau of Labor Statistics, with adjustments reflecting
company-specific factors (such as age, profitability, location and economic
conditions). Contact us if you have questions regarding owner compensation rules.