(Art Credit: Pedro Gomes)

If your freelance business is on a significant growth trajectory, congratulations! All of your hard work is paying off, and you may be considering switching your entity type from a sole proprietorship or limited liability company (LLC) to an S-corporation (S-corp) to take advantage of the payroll tax savings and other benefits (you can read about entity selection more fully here).

The payroll tax savings related to S-corp entities are a key consideration when deciding whether to form or transition your existing entity to an S-corp. However, if you do so, you need to make sure to calculate whether it is worth doing so from a tax and overall financial perspective. A tax professional can help you with this, and you may want to give engage one because of the potential negative implications if you elect to be an S-corp without fully understanding the structure of the entity (you are an employee, shareholder, and the CEO), new tax obligations, and the reporting considerations of the IRS.

Understanding the implications of reasonable compensation for S-corp freelance businesses.

Reasonable compensation is one of the key components to calculating the benefits of having your freelance business entity as an S-corp. This is an area few business owners are familiar with, but it is critically important.

For example, when you are an S-corp shareholder, the IRS monitors the distributions and wages you receive from your company to ensure they are reasonable compensation, and you should, too.  Here is why: As an S-corporation shareholder, you will pay into the federal Social Security and Medicare system based upon the W-2 wages you pay yourself and your employees. S-corp shareholders also pay themselves distributions. Wages are subject to Medicare and Social Security taxes; however, distributions are not. As an owner, you become a shareholder-employee of your entity. This is one of the distinguishing characteristics of an S-corp.

In the eyes of the IRS, corporate officers are specifically included within the definition of employees for the Federal Insurance Contributions Act (FICA, which funds Social Security and Medicare), Federal Unemployment Tax Act (FUTA), and federal income taxes.

All employers must calculate FICA and FUTA taxes and withholdings correctly to avoid serious tax penalties, and the formula isn’t always simple. When corporate officers perform services for the entity and receive or are entitled to receive payments, their compensation is generally considered wages. In most instances when you have an S-corp, you should treat payments for services to officers as wages and not distributions. This does not mean a shareholder-employee cannot receive distributions; however, wages must be paid first then distributions can be considered. It comes down to accurately paying the various tax requirements.

Another way to think about reasonable compensation is the reasonable value of the services rendered to your entity, by you. For example, what would you have to pay someone to perform your services if you had to hire from the external market?

Other considerations include:

• Do you work for another employer, even part-time?
• Do you derive substantially all of your income from your entity?
• How much time and effort do you devote to the business?

Given all of these factors, how do you begin to determine reasonable compensation? The key to establishing reasonable compensation is figuring out what you, as the shareholder-employee, did for the S-corp as compared to non-shareholder employees and services of other shareholders in the generation of gross income.

Shareholder employees should also be compensated for the administrative work they perform in addition to the generation of gross income. Again, if you had to hire an admin to perform the admin duties you are performing, what would this cost? This cost becomes part of your “reasonable compensation.”

Distributions should not exceed the compensation shareholder-employees pay themselves. Even if your entity loses money, you may be required to pay yourself reasonable compensation, if you plan to take distributions. A shareholder-employee cannot take distributions in lieu of wages.

However, a shareholder-employee does not have to cash infuse the business in order to pay shareholder-employee wages. In summary, if you want to take distributions you must pay wages first, then take distributions that do not exceed your wages.

Avoiding potential tax issues related to reasonable compensation in your s-corp freelance business.  A key question to keep in mind is, “What happens if I do not pay myself reasonable wages and the IRS comes knocking?”  

In the event of an audit, the IRS has the option to recharacterize “distributions” to wages for multiple years. The burden of proof is on you, the shareholder-employee to prove you paid yourself, and any other shareholder-employees fair market value or replacement cost for the services rendered to the entity.  Should the IRS not agree with you, your recharacterized distributions become wages subject to the taxes referenced earlier. This also means preparing and filing various payroll tax returns and W-2s to the respective tax agencies. The biggest kicker of them all is the penalties and interest assessed on the recharacterized wages and late tax filings. In most instances, the interest and penalties far exceed the taxes owed.  

The bottom line on reasonable compensation? Play it safe, pay yourself as you would an employee with similar training, education, work experience, and contributions to the business. It is a lot easier to pay into the system on the front end than to pay on the backend. Shareholder employees can benefit from distributions, but not at the expense of payroll tax avoidance.  If you are considering transitioning your growing freelance business to an s-corp, be sure to make the decision fully informed of all of the tax consequences, especially those related to reasonable compensation.