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One of the attractions of an S-Corporation is the ability to reduce Federal Insurance Contributions Act (FICA) tax liability by classifying part of the individual taxpayer’s income as distributions rather than as wages. Wages are subject to FICA, while distributions are not. This is a benefit for the individual taxpayer and for the business because they are both subject to the FICA tax liability.

To prevent all of an individual taxpayer’s income from the business being classified as distributions, which would permit the individual taxpayer and the business to avoid FICA tax liability entirely, the IRS requires part of the individual taxpayer’s income to be classified as wages. The problem with this arrangement has been the limited guidance from the IRS on how much income can be permissively classified as distributions and how much must be classified as wages. The instructions for Form 1120S, the IRS form used by a business when it makes its S-Corp election, state only that an S-Corp’s payments must be classified as wages to the extent the amounts are “reasonable compensation” for services rendered to the business.

The general (and unwritten) rule for determining whether an amount classified as wages is “reasonable” is whether it exceeds the amount classified as distributions. Many CPAs have been more conservative and have traditionally recommended a 60/40 allocation, classifying more income as wages to avoid an audit or an adverse tax ruling. Unfortunately, these general rules tend to lose their effectiveness when the business has significant profits and the amount of income classified as wages exceeds $110,100.

Making sure to maximize the amount of income classified as distributions is important because it results in significant FICA tax savings for the individual taxpayer as well as for the business. However, not classifying enough income as wages can be a huge problem. Unusually low wages when compared to distributions can draw unwanted IRS scrutiny and an audit. An unfavorable audit will likely result in some portion of the distributions being reclassified as earned income for federal income tax purposes, which results in a deficiency assessment (i.e., a tax bill), interest on those unpaid taxes, and IRS penalties.

So how can an S-Corporation business-owner know how much income can be permissibly classified as distributions compared to wages? A recent federal court decision provides some guidelines.

In Watson v. United States, the court held an S-Corp accounting firm was liable for additional taxes, interest, and penalties when it classified $24,000 as wages and $203,651 as distributions for one year of income payments it made to its owner. The result itself is not surprising. But, the guidance provided by the court in determining $24,000 was not “reasonable compensation” is helpful.

The court explained that the intent of the individual taxpayer and the business is only one of many considerations in the analysis of whether compensation is reasonable. Other relevant considerations include, but are not limited to:

(1) the individual taxpayer’s qualifications (more qualified, higher wages);

(2) the nature, extent, and scope of the individual taxpayer’s work (more involved, higher wages);

(3) the size and complexities of the business (larger and more complex, higher wages);

(4) a comparison between wages and the gross and net income of the business (wages should be higher if income of the business is higher);

(5) the prevailing general economic conditions (better economy, higher wages);

(6) a comparison of wages with distributions to other stockholders (distributions should be comparable to those of other shareholders);

(7) the prevailing rates of compensation for comparable positions in comparable businesses (wages should be close to those of the person with a similar position in a similar business);

(8) the wage policy of the business for all employees (wages should be similar to those of other employees in the business and not lower than a subordinate employee’s wages); and

(9) in the case of small businesses with a limited number of officers, the amount of compensation paid to the individual taxpayer in previous years (current wages compared to historical wages should show reasonable trend).

Through the Watson case, the court provided a framework for an S-Corp business owner to analyze whether “reasonable compensation” is being paid as wages. This will help provide guidance for maximizing the FICA tax benefit of an S-Corp through the proper classification of income between wages and distributions. S-Corp business owners are encouraged to consult their attorneys and accountants to determine whether their current classifications are appropriate in light of the guidance from the court.

If you have any questions concerning the classifications used by your business, please contact any of the attorneys in our Business Services Group.

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This article is for the purpose of providing general information only. It does not provide legal advice for any particular person, association, entity, group, or situation. This article is not a substitute for competent legal advice from a licensed attorney. Because your particular situation may be unique, you are encouraged to consult with your own attorney regarding your situation. Nothing contained in this article creates an attorney-client relationship between you and Mallor Grodner LLP.