1120S Reasonable Compensation

[ILLMAS]

A real estate agent formed an LLC and made the election to be treated as an 1120S, when she makes a sale, her commissions are paid to the LLC, then she draws a salary, here are my questions:

Since she is the one that is making the commission, the LLC is really not providing a service (how I see it), shouldn't the whole commission be subject to S/E tax?

Let say the commission earned for a given month is $5,000, she only draws a salary of $1,500 for that month, the difference stays in the bank account, so she will pay ordinary tax on $3,500.  Would this be considered a reasonable compensation?

 

 

[Abby Normal]

She is acting as an agent of the LLC/S corp. In this case, the only reasonable salary is 100% of the net profit of the S corp, unless she can provide a good reason for the S corp retaining cash. But if she's distributing all the cash, she's just evading SE tax.

[Lee B]

Copied from Forbes:

Late December’s Fleischer v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleischer, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.

The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.

The Facts of Fleischer: Setting up an S Corp to Avoid Self-Employment Tax

Fleischer is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleischer was the president, secretary, treasurer and sole shareholder of the corporation. Fleischer entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleischer also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleischer individually on various Form 1099’s over the years.

The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleisher paid employment tax on his wages from the S Corp. And while Fleisher’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

Fleischer’s S Corp paid him a salary of about $35,000. The net income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid the self-employment income tax if that income were earned directly by the shareholder/employee or the employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net income.

Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.

As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context

 

The IRS position has been pretty consistent for some years. However as a practical matter the audit rate for S Corporations has been very low, less than 1 % I believe.  As a result, I think that there are probably thousands of similar S Corporation returns that have been filed who are using this exact strategy.

I don't know if the IRS even has enough manpower to audit all of these returns ?

[ILLMAS]

1 hour ago, cbslee said:

Copied from Forbes:

Late December’s Fleischer v Commissioner involves facts that are common among many small business service-providing taxpayers wishing to minimize self-employment liability by setting up S Corporations and funneling service income to those corporations. Unfortunately for Fleischer, the Tax Court found that he faced a sizable self-employment tax liability as it reallocated income that was reported on the S Corporation’s 1120-S to his Form 1040.

The case is in the category of who is the appropriate taxpayer, an issue that sometimes gets murky when taxpayers are dealing with closely or solely-held separate entities. I will summarize and simplify the facts somewhat and hone in on why the taxpayer lost despite the plans of both a CPA and lawyer advising on his tax structure.

The Facts of Fleischer: Setting up an S Corp to Avoid Self-Employment Tax

Fleischer is a licensed financial consultant. Based on the advice of his CPA and lawyer, he set up an S Corporation. Fleischer was the president, secretary, treasurer and sole shareholder of the corporation. Fleischer entered into an employment agreement with the S Corporation, and pursuant to that agreement the S Corp paid him a salary in his capacity as financial advisor. In his individual capacity, Fleischer also entered into contracts with financial service companies Mass Mutual and LPL. Those contracts generated significant commissions, which Mass Mutual and LPL reported to the IRS and to Fleischer individually on various Form 1099’s over the years.

The key to the employment tax savings when all works well in this structure is that the S Corp pays a salary less than the gross receipts it receives. The shareholder/employee has employment tax liability to the extent only of the wages that the S Corp pays to the shareholder/employee. Fleisher paid employment tax on his wages from the S Corp. And while Fleisher’s status as sole shareholder meant that all of the S Corp’s income would flow through to him, the nature of the income matters. Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

Fleischer’s S Corp paid him a salary of about $35,000. The net income the S Corp earned varied over the years, going as high in one year as about $150,000. When, as was the case here, the S Corp’s wages paid are less than its net service income, the shareholder/employee can potentially avoid the self-employment income tax if that income were earned directly by the shareholder/employee or the employment tax if the S Corporation does not pay a salary commensurate with the corporation’s net income.

Underlying this form, however, is the IRS’s ability to allocate the income to the party who truly earns the income. In addition, the compensation the S Corporation pays to its shareholder/employee must be reasonable; if too low IRS can argue that some of the distributive share should be characterized as compensation (Peter Reilly discusses one such situation in S Corporation SE Avoidance Still a Solid Strategy). The taxpayer’s reporting of the income and the mere creation of a separate entity do not give the taxpayer unlimited discretion to treat the income in the way most favorable to the taxpayer.

As an important aside, the consequences of an LLC earning service income differ from that of an S Corporation. When an LLC earns service income, the distributive share of partnership income allocated to members of an LLC is generally subject to self-employment tax. This is a key difference between S Corporations and LLCs in this context

 

The IRS position has been pretty consistent for some years. However as a practical matter the audit rate for S Corporations has been very low, less than 1 % I believe.  As a result, I think that there are probably thousands of similar S Corporation returns that have been filed who are using this exact strategy.

I don't know if the IRS even has enough manpower to audit all of these returns ?

Will share, thanks

[Terry D EA]

8 hours ago, ILLMAS said:

A real estate agent formed an LLC and made the election to be treated as an 1120S, when she makes a sale, her commissions are paid to the LLC, then she draws a salary, here are my questions:

Since she is the one that is making the commission, the LLC is really not providing a service (how I see it), shouldn't the whole commission be subject to S/E tax?

Let say the commission earned for a given month is $5,000, she only draws a salary of $1,500 for that month, the difference stays in the bank account, so she will pay ordinary tax on $3,500.  Would this be considered a reasonable compensation?

 

 

As I think this thru, the structure that is setup is the best way to setup a real estate agent. Your client works for the LLC (hence the reasonable wage) and all commissions are paid to the LLC as you say. Because of the S-Corp treatment, all of the commissions are not subject to the SE tax regardless of whether she earned all of them or not. Again, she is working for the LLC and the LLC is a real estate business. This is one of the benefits of the S-Corp structure. Yes, the total earnings of the S-Corp pass thru to her and not subject SE tax. However, she does not have to take all of the income/earnings at one time thus negating the total amount as subject to the SE tax. The S-Corp should have an AAA and an A&E account setup so the shareholder can take a distribution at a later time tax free which is also known as a distribution of basis. The tax was paid on the S-Corp earnings when it passed through. Again, the only amounts subject to the SE tax are the wages.

>>>>>Since she is the one that is making the commission, the LLC is really not providing a service<<<<< The LLC does not provide a service but is a business which the shareholder is the employee (who should be to avoid problems with the IRS) who is providing the service.

As far as determining a reasonable wage, the article below will shed some light on this. It is a conundrum at best trying to determine a reasonable wage and explain it to your client how you arrived at it as well.

 

http://www.thetaxadviser.com/issues/2011/aug/nitti-aug2011.html

I hope I haven't added too much confusion to this.