This month we will dive into two more complex examples: The first explores Reasonable Compensation and look back periods. The second explores how basis and loans affect Reasonable Compensation.
Example 4: Scott Stone is 100% owner of Stone Concrete, an S Corp. In 2015 Stone Concrete had a net profit of $187,000 before considering Scott’s salary. Scott’s Reasonable Compensation figure for the services he provided to his S Corp was calculated to be $78,950. Scott elected to take NO distribution from Stone Concrete for 2015. Therefore Scott can choose to also take zero Reasonable Compensation.
In 2016 Stone Concrete has net profits of $220,000 before considering Scott’s salary. Let’s assume Scott’s Reasonable Compensation figure remains the same as 2015. After consulting with his CPA Scott elects to take $400,000 out of Stone Concrete. Scott will receive Reasonable Compensation of $157,900 and a post wages distribution of $242,100.
Analysis: For a multi-year scenario we fall back to the IRS guidelines: S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made. Because the distribution Scott is making in 2016 is the product of earnings from 2015 and 2016, Scott must pay himself Reasonable Compensation for 2015 and 2016 ($78,950 + $78,950 = $157,900).
A multi-year scenario like Scott’s always generates three interesting questions: What, How & Why:
Last as a cautionary tale let’s explore how an S Corp can lose money and still be required to pay Reasonable Compensation. Example 5: Scott Stone is 100% owner of Stone Concrete, an S Corp.
Scenario 1: If Scott properly classified and treated his $60,000 transfer to Stone Concrete as a loan according to IRS and court guidelines, then he can repay $30,000 of the loan to himself without having to pay Reasonable Compensation first. Stone Concrete’s net profit remained unchanged at $17,000.
Scenario 2: If Scott did not properly classify and treat his $60,000 transfer to Stone Concrete as a loan according to IRS and court guidelines, then the loan was, in fact, additional paid in capital (basis) and the repayment of $30,000 was actually a distribution (return of basis) not a loan repayment. Because Reasonable Compensation needs to be paid before any distributions can be taken, Scott must reclassify his distribution as wages.
When reclassifying the $30,000 of loan repayment as wages Stone Concrete will incur employment taxes of $2,295 for the $30,000 salarypaid to Scott. Stone Concrete will therefore be pushed into the red, changing the $17,000 net profit into a -$15,295 loss ($17,000 – $30,000 – $2,295).
This Scenario assumes Scott’s CPA caught the issue and treated it properly. If, however, this reclassification was due to an IRS Reasonable Compensation challenge, Stone Concrete’s losses would have been significantly higher after interest and penalties are assessed. For more on this see Glass Blocks Unlimited V. IRS.
Anything that compensates the S Corp owner can be re-characterized as wages, including personal expenses paid by the S Corp or “loans” to the S Corp owner. At the end of the day a distribution of any kind will trigger the requirement to pay Reasonable Compensation for services provided. Best practice is to know what the value of those services are and pay that amount in Reasonable Compensation before taking a post-wages distribution of any kind.