The IRS Has its Eye on “S” Corporations

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I have gathered from several responses to my prior post on “C” corporations versus “S” corporations that many active real estate investors prefer the “S” status.  The reasons cited for “S” status are flow through tax treatment, i.e., you do not have a separate taxable entity to contend with, and employment tax minimization.

For many business owners, it is the second reason that piques their interest.  The allure of escaping 13.3% additional tax on the first $106,800 in earnings is a tempting treat that is difficult to ignore when it feels like every governmental body is out for a piece of your earnings. (Note. Any wages above 106k are subject to 2.9% Medicare tax.)  This is exactly what inspired Mr. Watson in 2002 and 2003 to keep his salary at $24,000 and take distributions of $175,000 annually.

As with most strategies, everything works out until it is challenged and its constitution is tested.  The IRS recently challenged Mr. Watson and a district court concluded that Mr. Watson’s salary was unreasonably low, and allowed IRS to reclassify over $134,000 as salary.  This cost Mr. Watson over $48,000 in taxes, penalties and interest.

As a real estate investor, you might be wondering how do you determine a reasonable salary?  Obviously, each situation will be different so the IRS issued Fact Sheet 2008-25, that lists some factors that courts have considered in determining reasonable compensation:

    tax, corporation, salary

  • 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.

Many of the items on this list center around the amount of time and effort you devote to your business.  If you are the sole employee in your real estate corporation then it is reasonable to conclude that your salary will be on the higher end of the spectrum.  A rule of thumb that I tell my clients is at a minimum, factor on a 50/50 match on the first 110k in revenue.

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  1. I got rid of my S-Corp after only three years for the same reason you did. Lenders made getting a new real estate loan the impossible dream. One file, back in the day, took me almost 90 days, and it must of weighed more than my dog at the time. 🙂 I vowed ‘never again’. Since I’ve been an employee of my C-Corp, it’s been smooth sailin’.

  2. As long as you don’t go crazy with the salary/dividend split I think you are fine. Thanks for the fact sheet Clint! I didn’t know such a thing existed. The IRS guidance generally errs on the side of them keeping as much of your hard-earned money as they can.

  3. Well, so if the guy had been a little more reasonable in his estimate, do you think he would have been fine? $24k really is kind of ridiculous, even in these market conditions.

  4. Clint,

    How much money do you think I need to make before I have to get an S-Corp for my business? I am new real investor and I will be getting paid on two wholesale deals and rehab project where I did a joint venture with my investor in the next 2 weeks. The total income from those 3 projects is going to be around 20k. The reason why I am asking is b/c I was a mortgage broker before and certain deals I closed I would be paid via 1099. The one year my 1099 income was 17k and I didnt have to pay anything in taxes, I acgually got money back when I filed my taxes that year.

    I look forward to hearing your response.

  5. Anthony,

    How much do you think you will make this year? If you can expense everything out on your Schedule “C” then you should wait on incorporating unless you are looking for some liability protection. Ordinarily I would tell someone in your situation to set up a corporation for the particular type of business you are engaged in at present.

  6. Dear Mr. Coons,

    Thank you for an interesting article. I thought it would be a kindness to point out a common grammatical pot-hole: ‘peak’ one’s interest vs ‘pique’ one’s interest. The correct word is ‘pique’.

  7. Interesting Clint. When you say “factor on a 50/50 match on the first 110k in revenue,” you do mean DISTRIBUTIONS, correct? There is often a significant difference in the dollar amount of distributions to the employee/owner and the “revenue” generated by the corporation. Or are you referring to some other number?

    I agree with Bryan that you are pretty much safe if you are reasonable with your salary/dividend split. After all, Watson had 20 years experience as a CPA AND a graduate degree in tax yet he was taking a salary less than that of a recent college graduate. Of COURSE that raised a flag with the IRS.

    • Interesting. The IRS appears more lenient than you Clint 🙂 They said that Watson should have claimed a salary of a bit more than $91K – based on the $2mill in revenue that’s about 4% of revenue. It does, though, work out to be a shy more than 50% of distributions.

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