IRS Commissioner Mark Everson has indicated that this research is critical for the IRS achieving its strategic goal "of ensuring that corporations and high-income individuals are paying their fair share."

S corps are the most common corporate entity, with their numbers having risen from 724,749 in 1985 to 3,154,377 in 2002, the latest year for which data is available.

The study will examine 5,000 randomly selected S corp returns from tax years 2003 and 2004 to try to establish the extent to which business owners are reducing their compensation and taking distributions in order to avoid payroll taxes.

"In some cases, owners are taking little or no compensation while working full time in their business, but they are taking large distributions," said Jim Layton, director of Fiducial's Systems Support and Development (SSD). "The IRS is reviewing these returns to ensure that business owners are taking reasonable compensation and not avoiding payroll taxes."

To avoid the IRS classifying distributions as compensation, Layton said owners should evaluate the work they perform as an employee and determine what they would pay a non-owner to perform those duties. In doing this evaluation, they should not take into consideration the risks of ownership or their capital investment -- just the labor necessary.

"The reasonable compensation for the work performed should be paid as salary," he said. "The reasonable compensation is a judgment issue, and it's much easier to identify unreasonable compensation. If the business owner can show that he took the time and effort to evaluate the position and can show comparable salaries for the work performed, he will have support for reasonable compensation."

Gene Polley, a senior business advisor in Fiducial's San Diego, Calif., office, noted that a primary benefit of owning an S corp is paying yourself a salary which is subject to Social Security tax.

"The salary is typically less than the total profits of the business so those profits that remain get taxed, but there are no Social Security taxes on the remaining monies," said Polley. "By contrast, if you were a sole proprietor everything would be taxed. The problem is how to determine reasonable compensation?"

Doing the right thing for the right reasons

With the IRS paying more attention to compliance, Randy Penn, branch manager of Fiducial's Arvada, CO, office, advises S corp owners to pay themselves a fair wage.

"We're not making that recommendation to avoid an audit," said Penn. "We're making the recommendation because it's appropriate for tax policy and for businesses since it allows them to properly show what's in the business, and it values their time in the business."

Penn explained that proper tax planning dictates you should pay yourself as S corp distributions everything above reasonable compensation for everyone that works in the business. In determining reasonable compensation, he noted that owners should find out what they would have to pay somebody to do their job because S corp earnings are intended to compensate for both the intellectual and monetary capital that the owner put into the business.

"The salary is intended to compensate that individual for the management and operation of the business as well as the clerical work that same person ends up doing," he said.

Internet services such as Monster, CareerBuilder and Salary.com can help owners pinpoint a salary range for a specific position which may be reasonably close to what they are performing.

According to Penn, what set off IRS alarms were owners "not taking as salary the money they were taking out of the business to support themselves -- so it was being paid out and never subjected to payroll taxes."
 
For example, if an owner takes an unreasonably small salary, or none at all, and takes all the profits out as distributions, this will send up the red flags because they are not paying the FICA and Medicare taxes that an employee pays.

The best way to avoid an audit, Penn said, is to try and do the right thing for the right reasons.

"The right thing is to pay yourself a salary as though it was someone you had to hire to do the job because that's what it would take to run the business," he said.

A benchmark you can hang your hat on

In Greenland, N.H., Fiducial franchisee Van Ballantyne asks his clients what they would have to pay to hire somebody to do the work if they needed to bring in a manager.

"For the fundamental operation of the business we kind of have to start using that as a benchmark," said Ballantyne.

Of course, there are extenuating circumstances for determining reasonable compensation, especially if the business is in the start-up mode or in the early going and hasn't yet built up any profits.

"You have to factor that in," he said. "You can't take a $100,000 draw if the business isn't producing profits, so you start with the benchmark from a salary survey, and that's what you hang your hat on."

Ballantyne cited two factors that contributed heavily to the IRS investigation: The 1990s are over and the tax surpluses are gone. With Congress charged with finding additional sources of income, he said they are looking to IRS Commissioner Everson and tasking him with increasing tax revenues.

On the IRS investigation, Ballantyne believes they will attack this issue fairly aggressively and may ultimately let the courts define reasonable compensation.

"The prudent position we're taking is to ask the client to pull something off the web and do some documentation to support whatever level of salary they take," he said.

It will be on a case-by-case basis

Sam Smith, a Fiducial franchisee in Middletown, M.D., observed that the IRS may try to crack down on S corps, but he doesn't see them going that route since they would have to set a guideline to fit all businesses and all industries.

"It's going to have to be on a case-by-case basis," said Smith. "You're looking at a situation where if I'm a sole shareholder and I'm the one responsible for running the business then the IRS can make a pretty good argument. But how can you say that every dime should be in the form of wages, then being able to come up with a calculation to determine that? I just don't think they can."

Smith said the IRS will find that reporting has been abused by S corps but he doesn't see them coming up with "a fix-all" solution.

"It's going to be way too costly," he said.

He informs his clients that the IRS is going to focus first on the individual who claims zero compensation.

"Once a year I tell every client that has an S corp not to report zero compensation," Smith said.

In addition to risking an audit, he also reminds clients that taking a small salary will reduce the amount which can be contributed to a retirement plan.

"Without compensation you cannot contribute to these plans," he said. "You have to have earned income to contribute."Return to Small Business Insights

STEPHEN PAREZO is the Media Manager for Fiducial.

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