While it’s normal for S corporation business owners to receive lower wages and larger shareholder distributions to minimize payroll taxes, it’s essential to note that the IRS closely monitors S-corp compensation. If your wages are too low to be considered reasonable, the IRS can reclassify part of your shareholder distributions as payroll wages, resulting in an unexpected tax bill.
However, there’s good news. Reclassification issues are fixable, especially with the help of an experienced tax attorney. The sooner you respond to reclassification notices and take action, the sooner you can tackle this issue head-on. Call Wiggam Law at (404) 233-9800 to discuss your legal options now.
Key Takeaways
- Reasonable salary – The IRS watches S corps to ensure that owners are paid a reasonable salary for their work.
- Compensation reclassification – S corp owners who receive little or no compensation outside of shareholder distributions may find some of their distributions reclassified as wages.
- Reclassification consequences – Wage reclassification can lead to payroll tax assessments, penalties, and interest.
- Don’t ignore IRS notices – Ignoring reclassification notices may result in liens, levies, and other aggressive collection actions.
What Reclassification Means and Why the IRS Does It
S-corp owners are legally required to take a reasonable salary for work. The IRS wants to see that owners are being paid close to market rate for the work they do for the business.
When an S-corp owner gives themselves a minimal salary but also receives substantial shareholder distributions, the IRS may assume that they are intentionally underpaying themselves to avoid paying more in employment taxes.
When a tax return has red flags, the IRS may dig deeper with an audit to determine whether the owner is being paid a reasonable wage. Should the IRS determine that they’re not, they can reclassify some of the shareholder distributions as wages.
Basically, this means that some of your previously paid distribution income is now being treated as taxable payroll wages. The amount that was reclassified is subject to Social Security and Medicare taxes, and then payroll tax liabilities are recalculated to account for the new payroll amount. Penalties and interest are added, and you’re billed for the new tax balance owed.
How the IRS Calculates the Adjustment
Per the IRS, certain payments must be treated as wages that serve as reasonable compensation for services provided to the corporation. There’s no set formula that the IRS uses to determine what would be considered reasonable compensation. The IRS has the freedom to determine fair compensation based on the circumstances of each case. Some of the factors they take into consideration include:
- The individual’s experience, training, and education.
- The duties and responsibilities performed for the corporation.
- Company size and profitability.
- How much other employees of the business earn?
- Time spent working in the business.
- Comparable industry wages using resources like the Bureau of Labor Statistics and compensation databases.
- Local market rates.
Because there’s no set formula, different people are likely to come to different conclusions, which means there’s room for negotiating with the IRS.
Consequences After Reclassification
Once the IRS decides a new fair salary for you, the IRS uses that number to adjust your taxes in several different ways. First, they recalculate the Social Security and Medicare taxes you should have paid on that total amount. Second, the IRS could charge you several different penalties, such as the accuracy-related penalty and failure-to-pay penalty. Finally, the IRS charges interest on the additional taxes and penalties.
One of the most feared outcomes of this situation is the Trust Fund Recovery Penalty (TFRP). If a substantial amount of shareholder distribution income is suddenly considered taxable wages, it means the business should have paid payroll taxes on that money, withheld federal income tax, withheld FICA taxes, and deposited those taxes with the IRS. Even though those taxes were never actually withheld from the paycheck, the IRS views that money as trust fund taxes owed to the IRS.
If your business can’t pay this new tax bill, the IRS may move to assess the TFRP, which the IRS can seek to recover from one or more responsible individuals after completing Form 4180 interviews.
Notices You May Receive
There are several notices you may receive if the IRS believes you are being paid shareholder distributions in lieu of a fair salary. Some of the more notable ones are:
- IRS Letter 2205-B: This is an audit notice sent to businesses when the IRS is auditing a specific tax return.
- IRS Form 4564: This is a generic form sent to individuals and businesses when the IRS is requesting further information. They may ask for information on an officer’s duties, payroll logs, explanations for low or non-existent wages, and other related topics.
- Notice of Proposed Adjustment (30-Day Letter): If an auditor determines your compensation is unreasonable, they will issue a notice proposing an assessment of additional tax. This notice typically gives you 30 days to formally protest the findings and take your case to the IRS Independent Office of Appeals.
Your Options to Challenge the IRS Determination
There are a couple of different ways you can appeal reclassified wages. One method is to appeal the decision via the Independent Office of Appeals. The letter you receive regarding your proposed assessment or final assessment should include instructions on how to do this.
Another option is to reach out to the IRS to negotiate. This is one area where it’s important to have a tax professional advocating for you. There are so many factors that go into determining “reasonable compensation” that you really want to go into negotiations completely informed and ready to make your case. A tax attorney with experience in S corporation taxes can build a case supporting a lower salary and negotiate on your behalf, potentially decreasing your final tax bill.
What Happens If You Ignore the Reclassification
If you ignore notices from the IRS regarding reclassified wages, their proposed assessment will be officially assessed and added to your tax bill. From there, they go through the standard collection process.
You’ll receive multiple notices reminding you of your balance, slowly escalating until the IRS begins threatening liens and levies. If you continue to ignore the notices, you may find a lien placed on your assets or your assets levied to cover your tax bill.
Fixing Prior Years
Should you successfully negotiate a fair wage with the IRS, you can take the following corrective steps to fix previous tax returns and stop penalties and interest from continuing to accrue:
- Filing amended returns that list the newly-determined salary.
- Filing late W-2s listing the corrected wage amount.
- Adjusting your employment tax returns with IRS Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.
Completing these steps can be a fairly lengthy process that’s prone to errors, so it’s recommended that you consult a tax attorney with experience in S corp reclassified wage cases. In addition to handling the year or years under audit, your attorney can help fix other tax returns proactively and set you up for future compliance with the IRS.
Setting Up for Future Compliance
To ensure that you don’t face the same issue in the future, you’ll want to look into the salaries paid to other officers to ensure that others aren’t being underpaid.
Another thing to consider is creating protocols and documentation for setting fair wages for officers. Documentation outlining the expected work hours, work duties, comparable salaries, and factors accounted for in wage calculations can put you in a better position to negotiate should you face reclassification issues in the future.
How a Tax Professional Can Help
It’s important to consult with a tax professional at the first sign of trouble. The right tax professional can:
- Represent you during an audit.
- Appeal the outcome of an audit.
- Assist with negotiations after the IRS has determined what “reasonable compensation” should be.
- Manage payroll tax debt.
- Help prevent the Trust Fund Recovery Penalty.
- Communicate with the IRS on your behalf to avoid statements that increase your legal risk.
- Limit the scope of an IRS audit.
- Sequence corrections in a way that yields the best outcome for you.
While this situation is stressful and potentially expensive, the earlier you take action, the more legal options you have. S corporation tax attorneys can help navigate a wide range of problems, from S-corp election denials to any other IRS letters about your S-corp.
Call Wiggam Law at (404) 233-9800 or schedule a consultation online to discuss your next steps.
Frequently Asked Questions
Can I appeal the IRS reclassification?
Yes. If you respond before the deadline given in the notice sent to you, you can work through the appeals process. You may also be able to resolve the issue via direct negotiations with the IRS.
What if I can’t afford the payroll tax assessment?
There are payment possibilities available, such as installment agreements, penalty abatement, and currently not collectible status. Note that businesses applying for payment plans for payroll taxes typically only get two years to pay, unless they provide financial details to the IRS.
Will this impact my personal tax return?
Yes, if your distributions are reclassified as wages, both you and the company will owe payroll taxes on those amounts, which will increase your personal liability on your individual income tax return.
Should I amend past payroll tax returns?
If you choose to go this route, you should do it strategically with the help of a tax professional. Doing so incorrectly or without careful planning can increase exposure.
Sources:
https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-employees-shareholders-and-corporate-officers
https://www.irs.gov/instructions/i1120s
https://www.irs.gov/pub/irs-pdf/f1120s.pdf
https://www.irs.gov/pub/irs-utl/form4564.pdf
https://taxschool.illinois.edu/post/irs-audit-issue-s-corporation-reasonable-compensation/
https://www.irs.gov/irm/part8/irm_08-007-016
https://www.irs.gov/irm/part4/irm_04-008-010
https://www.irs.gov/newsroom/taxpayers-can-appeal-when-they-disagree-with-an-irs-decision
https://www.irs.gov/appeals/preparing-a-request-for-appeals
https://www.irs.gov/forms-pubs/about-form-941-x
https://www.irs.gov/pub/irs-pdf/f941x.pdf
