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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 a bunch of court 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 2019 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. So, there is a back end savings to the government that may not be reflected in the loss figures but that may be much less than the costs to the government relating to the foregone employment taxes.