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Push and Pull on S Corporation Shareholder-Owners

From an M&A standpoint, there is a considerable benefit to being the owner of an S corporation.  Assuming a 338(h)10 election is made, many buyers of these types of entities can receive a tax benefit through a step-up in basis (the amount of the stock purchase above that of the target company’s assets), which can be amortized over 15 years.  A portion of the value of this tax shelter can often times be additive to the purchase price that would be put forth otherwise.  Note that LLC entities can receive this same benefit.  From a day-to-day operations perspective, there are important changes taking place from a contracting and tax standpoint that S corporations should be mindful.

There is considerable pressure being places on the current Administration as well as the IRS to fix corporate tax “loopholes.”  One of these loopholes is the exemption from self-employment taxes on distributions to the shareholder-employee(s) of an S corporation.  Many are quick to point out that some business owners that take advantage of this exemption by taking distributions in lieu of salary and bonus in order to avoid self-employments taxes and increase “take home pay.”  As a result, the IRS has increased oversight of S corporations and the compensation paid to shareholder-employees, enforcing what is known as “Reasonable Compensation” standards.  Per the IRS website, “distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation.”  This raises interesting dynamics for government contractors, as their services are provided to, and compensated by the Federal government.  Further mudding the waters is the ongoing initiative by the Obama Administration to tie the maximum compensation to senior executives that can be considered allowable to the President’s salary, currently $400,000 per year.

For ease of demonstration, let’s take an S corporation that performs on 100% cost-plus contracts as a percent of its total revenue, and is wholly-owned by the CEO.  If the CEO decides to take all compensation though distributions, the company’s overall rate structure would be lower and they could theoretically put forth more competitive pricing for government contracts.  Assuming the CEO is heavily involved with day-to-day operations; this could raise a red flag with the IRS.  The shareholder-owner is avoiding the ~15.3% in employee-share and company-share of employment taxes (this rate may be lower based on maximum taxable earnings for Social Security taxes).  However, if that compensation, which is within the current limits, were paid in salary and bonus, the company would receive reimbursement for the owner’s compensation plus a nominal fee.  Granted, this assumes the company could still put forth competitive pricing to win the work.  The end result, the government pays more, the employee makes less, and the IRS collects ~15.3% of the total compensation which offsets some, but not all, of the increased cost.  The risk is essentially shifted from the owner to ensure the business performs to the government to pay the owner’s compensation.

Toss in the proposed lower allowable compensation caps, and there is an interesting dynamic that owners must navigate.  The Federal government wants to shift more compensation to unallowable, and the IRS wants to ensure reasonable compensation is paid to shareholder-owners in order to increase tax revenue.  S corporation owners will need to be mindful of balancing the two and using distributions carefully and accordingly to maintain profitability and compensation.

Contributors: Marc Marlin and Robert Dowling