IRS PUBLISHES S CORPORATION GUIDANCE EXPLAINING COMPENSATION, MEDICAL INSURANCE AND STOCK BASIS ISSUES

August 2009 

Scott E. Vincent, Partner 

The IRS recently published “Tax Resources for Small Businesses, Issue No. 2009-14” with useful information for S corporations on the proper employment tax treatment of payments made to shareholder-employees and officers. The publication also explains how 2% shareholder-employees of S corporations treat company-paid health insurance premiums and provides guidance on various S corporation stock basis issues.

Background

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. S corporation shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

S corporation shareholders may deduct their pro rata share of passed-through items only to the extent of their adjusted basis in the S corporation stock, determined by taking into account the increases in basis for their share of the S corporation income during the year, and the decreases in basis for non-dividend distributions for the year, plus any debt owed to these shareholders by the corporation.

S corporations are typically closely held entities, and the principal owners typically receive both compensation and distributions, health insurance coverage and other benefits. These owners also can have stock basis limitations on their ability to receive the benefit of flow-through losses on their individual return. The new IRS guidance provides good information on these three key areas.

Compensation

The guidance notes that S corporations must pay reasonable compensation to a shareholder-employee in return for services provided to the corporation before non-wage distributions may be made to the shareholder-employee. Courts have supported IRS's authority to reclassify other forms of payments to a shareholder-employee as a wage expense. Courts have found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation that should be classified as wages.
Similarly, distributions and other payments to a corporate officer must be treated as wages to the extent they are reasonable compensation for service rendered to the corporation. However, if an officer does not perform any services or only performs minor services and is not entitled to compensation, the officer is not considered an employee.

Some factors considered in determining reasonable compensation include:

• training and experience;
• duties and responsibilities;
• time and effort devoted to the business;
• dividend history;
• payments to non-shareholder employees;
• timing and manner of paying bonuses to key people;
• what comparable businesses pay for similar services;
• compensation agreements; and
• use of a formula to determine compensation.

Medical Insurance Premiums

The IRS guidance explains that health and accident insurance premiums paid on behalf of a greater than 2% S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee's Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. The IRS indicates that this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but is not included in Boxes 3 or 5 of Form W-2.

Under Code Section 1372(b), a “2% shareholder” (actually a more-than-2% shareholder) is any person who owns (or is considered as owning under the constructive ownership rules), on any day during the S corporation's tax year, more than 2% of the outstanding stock of the S corporation or stock possessing more than 2% of the total combined voting power of all stock of the S corporation.

A 2% shareholder-employee is eligible for an above-the-line deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation (and the shareholder or the shareholder's spouse is not eligible to participate in any subsidized health care plan). A medical plan is considered established by the S corporation if the S corporation paid or reimbursed the shareholder-employee for premiums and reported (a) the premium payment and (b) the reimbursement as wages on the shareholder-employee's W-2.

IRS Notice 2008-1 also provides guidance on this point, and provides that shareholders who purchase health insurance in their own name and paid for it with their own funds would not be allowed an above-the-line deduction. On the other hand, IRS stated that if the medical coverage plan is in the name of the 2% shareholder and not in the S corporation's name, a medical care plan could be considered to be established by the S corporation if it either paid or reimbursed the 2% shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2% shareholder's Form W-2.

S Corporation Stock and Debt Basis

The current IRS guidance notes that a Schedule K-1 (to Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc., reflects the S corporation's income, loss and deductions that are allocated to the shareholder for the year. It does not state the taxable amount of distributions, which are contingent on the shareholder's stock basis. If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis.

If a shareholder is allocated an S corporation loss or deduction flow-through, the shareholder must first have adequate stock and/or debt basis to claim it. And even when the shareholder has adequate basis, the shareholder must also consider at-risk and passive activity limitations that may bar a current deduction. The order in which stock basis is increased or decreased is important since both the taxability of a distribution and the deductibility of a loss are dependent on stock basis. The guidance lists the following key rules that S corporation shareholders should keep in mind:

• A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder's personal return, usually a long-term capital gain;
• Nondeductible expenses reduce a shareholder's stock and debt basis before loss and deduction items. If nondeductible expenses exceed basis, they are not carried forward;
• If the current year has different types of losses and deductions, which exceed stock and debt basis, the allowable losses and deductions must be allocated pro rata based on the size of the particular loss and deduction items;
• A shareholder is not allowed to claim losses and deductions in excess of stock and debt basis. Losses and deductions not allowable in the current year are suspended due to basis limitations;
• Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended losses or deductions in excess of stock and debt basis are carried forward indefinitely until basis is increased in subsequent years or the shareholder disposes of the stock;
• In determining current year allowable losses, current year loss and deduction items are combined with the suspended losses and deductions carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return;
• A shareholder is only allowed debt basis to the extent the shareholder has personally loaned money directly to the S corporation. A loan guarantee is not sufficient to allow the shareholder debt basis;
• If a shareholder contends he has contributed or loaned substantial funds to the S corporation, consideration should be given to whether the shareholder had the financial means to make the contribution or loan;
• Part or all of the repayment of a reduced basis debt is taxable to the shareholder;
• If stock is sold, suspended losses due to basis limitations are lost. The sales price does not have an impact on the stock basis. A stock basis computation should be reviewed in the year stock is sold or disposed of.

Conclusion

This recent IRS guidance provides a good overview on compliance issues for which S corporations and their shareholders are often audited. The IRS has a long-standing position challenging “under compensated” S corporation shareholders, and often seeks to recover employment taxes on distributions that should be classified as wages. S corporation shareholders also need to carefully navigate the payment and reporting of health insurance premiums. Similarly, it is important for S corporation shareholders to carefully track their stock and debt basis. Lending transactions involving shareholder guaranties are common sources of problems since the guaranties themselves do not create stock basis; this issue is easily addressed by having the shareholder obtain the loan directly and then loan or contribute funds to the S corporation. Taxpayers and practitioners should carefully review these key S corporation issues periodically so the problems outlined can be avoided or corrected.