Is your business structured as an S corporation, or is your sole proprietorship or LLC growing to the point that moving to an S corporation can save you significant tax dollars?
If so, beyond the entity selection, you need to make sure that you have an accurate reasonable compensation calculation to use, in order to take advantage of the payroll tax savings related to your S corporation election. In fact, these calculations could be one of the most important ones that many business owners have never even heard of.
What is reasonable compensation, and why is it so important?
When you’re an S corporation owner and shareholder, the IRS monitors the distributions and wages you receive from your company to ensure they are considered “reasonable compensation.” This means that it’s equivalent to what someone with the same skills, experience, and other qualifications would be paid. This calculation is also what will be used to determine the amount of the federal Social Security and Medicare payments that are due, based on the W-2 wages you pay yourself and your employees.
In the eyes of the IRS, corporate officers are specifically included within the definition of employees for the Federal Insurance Contributions Act (FICA, which funds Social Security and Medicare), Federal Unemployment Tax Act (FUTA), and federal income taxes. Therefore, all employers must calculate FICA and FUTA taxes, and withholdings, correctly to avoid potentially serious tax penalties. These calculations must be accurate, in order to avoid issues with audits or underpayment penalties from the IRS.
How do you calculate reasonable compensation accurately? Beyond just the market value of the owner, shareholder, or employee wages, there are several other factors to consider:
- Does the individual work for another employer part-time?
- Does all of your income come from your entity?
- What amount of time and effort do you allocate to your business?
With these questions in mind, you can begin to determine reasonable compensation, which should also include an amount for the administrative work you perform, in addition to the generation of gross income.
Another important point: If you plan to take distributions and your entity loses money, you still are required to pay yourself reasonable compensation. You can’t take distributions in lieu of wages; however, a shareholder employee does not have to put their own cash into the business to pay shareholder employee wages.
Understanding the implications of reasonable compensation for S corp freelance businesses
For example, when you are an S corporation shareholder, the IRS monitors the distributions and wages you receive from your company to ensure they are reasonable compensation, and you should, too.
Here’s why: As an S-corporation shareholder, you will pay into the federal Social Security and Medicare system based upon the W-2 wages you pay yourself and your employees. S corporation shareholders also pay themselves distributions. And while wages are subject to Medicare and Social Security taxes, distributions are not. As an owner, you become a shareholder employee of your entity. This is one of the distinguishing characteristics of an S-corp.
In the eyes of the IRS, corporate officers are specifically included within the definition of employees for the Federal Insurance Contributions Act (FICA, which funds Social Security and Medicare), Federal Unemployment Tax Act (FUTA), and federal income taxes.
All employers must calculate FICA and FUTA taxes, and withholdings, correctly to avoid serious tax penalties, and the formula isn’t always simple. When corporate officers perform services for the entity and receive, or are entitled to receive, payments, their compensation is generally considered wages. In most instances when you have an S corporation, you should treat payments for services to officers as wages and not distributions. This does not mean a shareholder employee can’t receive distributions; however, wages must be paid first before distributions can be considered. It comes down to accurately paying the various tax requirements.
Another way to think about reasonable compensation is the reasonable value of the services rendered to your entity, by you. For example, what would you have to pay someone to perform your services if you had to hire from the external market?
Other considerations include:
- Do you work for another employer, even part-time?
- Do you derive substantially all of your income from your entity?
- How much time and effort do you devote to the business?
Given all of these factors, how do you begin to determine reasonable compensation? The key to establishing reasonable compensation is figuring out what you, as the shareholder employee, did for the S corporation, as compared to non-shareholder employees and services of other shareholders in the generation of gross income.
Shareholder employees should also be compensated for the administrative work they perform, in addition to the generation of gross income. Again, if you had to hire an admin to perform the admin duties you are performing, what would this cost? This cost becomes part of your “reasonable compensation.”
Even if your entity loses money, you may be required to pay yourself reasonable compensation, if you plan to take distributions. A shareholder employee can’t take distributions in lieu of wages.
However, a shareholder employee does not have to cash infuse the business in order to pay shareholder employee wages. In summary, if you want to take distributions, you must pay wages first, and then take distributions.
Avoiding potential tax issues related to reasonable compensation in your S-corp freelance business
A key question to keep in mind is, “What happens if I do not pay myself reasonable wages, and the IRS comes knocking?”
In the event of an audit, the IRS has the option to recharacterize “distributions” to wages as far back as three years. The burden of proof is on you, the shareholder employee, to prove you paid yourself and any other shareholder employees fair market value or replacement cost for the services rendered to the entity.
Should the IRS not agree with you, your recharacterized distributions become wages subject to the taxes referenced earlier. This also means preparing and filing various payroll tax returns and W-2s to the respective tax agencies. The biggest kicker of them all is the penalties and interest assessed on the recharacterized wages and late tax filings. In most instances, the interest and penalties far exceed the taxes owed.
The bottom line on reasonable compensation? Play it safe and pay yourself as you would an employee with similar training, education, work experience, and contributions to the business.
It’s a lot easier to pay into the system on the front end than to pay on the backend. Shareholder employees can benefit from distributions, but not at the expense of payroll tax avoidance.
If you are considering transitioning your growing freelance business to an S corporation, be sure to make the decision fully informed of all of the tax consequences, especially those related to reasonable compensation.
