Timing of > 2% S-corporation shareholder salary

[equinecpa]

I have several > 2% shareholder S-corporation clients with whom I meet in November, review their records and determine a reasonable wage. Most of these clients have highly fluctuating revenue streams and it is only towards the end of the year that a good estimate of income can be determined. The client will take draws until that time, and in November or December determine a reasonable wage. The draws will be offset by the net wage check.

Someone suggested to me today that this isn't allowable, and that the shareholder needs to take a wage throughout the year. I don't see anywhere that says this and don't see why an annual wage wouldn't be reasonable?

Thoughts?

Carolyn

[kathyc2]

If instead of being an employee/shareholder, what if it was an unrelated employee? Would you write salary advances and then at the end of the year write a paycheck and deduct the advances? It's the same general concept, you are circumventing the 941 deposit timing rules.

[TaxGuyBill]

Although it would probably be highly frowned upon by the IRS, I also doubt if there is anything specific from the IRS that says it can't be done that way (I could be wrong though).

However, the Department of Labor is a completely different matter. Each State requires an employee to be paid on a regular basis (see link). It's possible that your State's DOL could have an exception for owner-employees or other exceptions (such as the company only having a few employees), but I suspect that in most States paying annually would be against the DOL rules.

https://www.dol.gov/whd/state/payday.htm

You could try a hybrid approach, and have the employee/shareholder regularly take a preset low-to-mid wage (or have it a set percentage of what they 'draw', and then you do the math for payroll). Then in November do your assessment to determine what the appropriate annual "reasonable wages" should be and then make whatever adjustments that you need to for the final quarter. In other words, they receive a low wage every week/two weeks/month, but then receive a "bonus" in November/December.

[kathyc2]

Although it would probably be highly frowned upon by the IRS, I also doubt if there is anything specific from the IRS that says it can't be done that way (I could be wrong though).

I'd say it's covered by the reasonable salary rule. If cash flow is such that money is available to take shareholder distributions is it reasonable for the shareholder/employee to work for "free" 11 months out of the year? In the event of an audit, I would guess IRS would say no and might assess late payment 941 penalties.

Personally, I won't determine for a client what a reasonable salary is. I ask them to think what they would expect to be paid if they were working for someone else doing what they do for the S, and also if they couldn't work for an extended time, what do they think they could need to pay an employee to cover their duties. If the amount they come up with seems unreasonably low, I advise them the IRS may not agree in the event of an audit.

[TaxGuyBill]

I'd say it's covered by the reasonable salary rule. If cash flow is such that money is available to take shareholder distributions is it reasonable for the shareholder/employee to work for "free" 11 months out of the year? In the event of an audit, I would guess IRS would say no and might assess late payment 941 penalties.

Good point. I glossed over the fact that the shareholder was regularly taking money out of the corporation. As you say, if the shareholder is receiving money, "reasonable compensation" must be met.

[Rapid Robert]

I meet in November, review their records and determine a reasonable wage. Most of these clients have highly fluctuating revenue streams and it is only towards the end of the year that a good estimate of income can be determined.

You're saying they have no idea during the year if they are profitable or not? Yet they can manage to take out significant cash? If that's supposed to be a joke, I don't get it.

Most tax professionals have "highly fluctuating revenue streams" too. Does that mean you have no idea until November whether you had a good tax season or not?

[Roland Slugg]

The word "draw" is one that's used to describe the funds withdrawn by the owner of an unincorporated business (i.e. Schedule C), or by a partner of a p'ship. An S Corp is a corporation, and that puts payments to its shareholder-employees in a completely different light.

As another has already pointed out above, if the corporation has the funds to make the "draws" all during the year, there is very little to justify waiting until close to the EOY to then reclassify them as salary and treat them as paid all at once late in the year. The IRS could very well assess penalties for unremitted FWHT, FICA and Medicare, based on the advances/draws taken during each month and quarter during the year, and those P&I assessments could be sizable. The state(s) would likely do the same

My advice is that you promptly advise all your S Corp clients (and your C Corp clients, too, if they are doing the same thing), to promptly start treating payments to their shareholder-employees the same as all other employees.

[equinecpa]

You're saying they have no idea during the year if they are profitable or not? Yet they can manage to take out significant cash? If that's supposed to be a joke, I don't get it.

Most tax professionals have "highly fluctuating revenue streams" too. Does that mean you have no idea until November whether you had a good tax season or not?

Not a joke-most of these clients are in the same industry where much of their income is earned in the latter 3 months of the year. If they are non-profitable a zero salary is reasonable is it not?

As another has already pointed out above, if the corporation has the funds to make the "draws" all during the year, there is very little to justify waiting until close to the EOY to then reclassify them as salary and treat them as paid all at once late in the year. The IRS could very well assess penalties for unremitted FWHT, FICA and Medicare, based on the advances/draws taken during each month and quarter during the year, and those P&I assessments could be sizable. The state(s) would likely do the same

If the shareholder has significant previously taxed undistributed capital would that sway your thoughts in reclassifying the draws? The client could draw down those through the year, assess profitability in last quarter, determine reasonable salary and take that salary and loan it back if the company can not afford the cash flow?

I agree that a regular smaller salary with a bonus at year-end would be far preferable.

[kathyc2]

Maybe I'm reading this wrong, but it sounds like reasonable salary is determined by you each year based on profitability? There are no hard and fast rules as to what is reasonable, so again I caution against you being the one making the decision as to what is reasonable rather than the shareholder.

Does the "reasonable" salary vary significantly based on profitability? If so, does time and effort of the shareholder each year vary in relationship to the profits?

Does the business have other employees? Does the business provide goods or services? Is the capital investment for equipment and inventory large or small?

Just my opinion, but the above items are more important to reasonableness than profits alone.