What Farm Clients Need to Know About S Corporations and Self-Employment

Many farm operations elect S corporation status to manage taxes, but they are often unprepared for the complexities of S Corporation employment tax rules. Misclassifying wages or distributions can trigger IRS scrutiny and unexpected liabilities. By understanding how S corporation self-employment tax works and the reasonable compensation rules, tax practitioners can help agricultural clients stay compliant with the requirements.

In this article, we’ll cover key considerations for farm clients using S corporations.

Why Farmers Choose S Corporations

The S Corporation election has tax advantages that make it an attractive option for some farm businesses. Unlike with C corporations, S corporations offer a single layer of taxation. S corporations are pass-through entities, so the corporation doesn’t pay income tax on its income. Instead, the income flows through to the shareholders and is taxed once at the individual level. On the other hand, C corporations pay a corporate income tax, and then shareholders also pay individual income tax on any dividends received from the corporation.

Making an S corporation election can also save farm businesses on self-employment income tax. Be careful, though. One common misconception is that S corporations eliminate self-employment tax. S corporation shareholders are required to take a salary from the business. The salary is still subject to Social Security and Medicare tax, like any other employment salary; the shareholder pays half, and the business pays the other half. After taking a salary, S corporation shareholders can take distributions that are not subject to self-employment tax.

S corporations also offer estate planning advantages, including the ability to pass the shares of the S corporation through a grantor trust.

The Reasonable Compensation Requirement

A major tripping point for many S Corporations is the reasonable compensation requirement. S Corporations must pay their shareholder-employees, including officers, a salary in exchange for their services.

Many S Corporation shareholders find it challenging to determine a reasonable compensation amount and may seek advice from their tax accountant. The IRS considers reasonable compensation the amount a similar business operating under similar circumstances would pay for the services performed by the shareholder.

For farm operators, reasonable compensation can vary depending on the size of the operation, level of experience, and duties performed. An experienced farmer operating a large farm may calculate a higher salary than one who runs a small operation.

There are a few acceptable methodologies clients can use to determine their reasonable compensation.

1. Cost approach: assigns a comparable salary to each of the different duties a shareholder performs (administrative, operational, etc.) and then totals them
2. Market approach: uses a similar salary to someone else in a similar industry position at another company
3. Income approach: considers whether an investor would consider the return on investment in the company fair, given the owner’s compensation

The IRS lists the following factors to consider when calculating reasonable compensation:

• 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
• The use of a formula to determine compensation

When an S Corporation fails to report an amount on line 7 of the Form 1120-S income statement (Compensation for Officers), the IRS may see this as a red flag. Taking the time to calculate a reasonable salary is important to avoid IRS scrutiny and the possibility of the IRS reclassifying distributions as compensation. If the IRS reclassifies distributions, the taxpayer may be subject to additional payroll taxes as well as penalties and interest for underpaid wages. They also run the risk of the IRS auditing other tax years, which can result in even more penalties.

Tax practitioners should also be aware of the possibility of paid preparer penalties if they do not follow IRS guidelines regarding reasonable compensation under IRC §6694:

• Unreasonable position: $1,000 or 50% of income from return prep
• Willful or reckless conduct: $5,000 or 75% of income

Practical Guidelines for Farm Operations

Tax practitioners should advise clients to maintain detailed records to substantiate their salary calculation as it is up to the corporation to defend that the amount is reasonable. Clients should define their job description and document the services they provide to the farm. For example, a farm supervisor may have operational duties for running the farm but may also perform administrative tasks that they want to ensure are documented and appropriately compensated for. Farmers may consider tracking the number of hours they work for each type of service they provide for the business.

Farmers also want to be sure they are balancing their W-2 wages with their pass-through distributions. Each farm’s reasonable salary amount may vary depending on the corporation’s facts and circumstances, but farms should be aware they risk the IRS reclassifying distributions as wages if the reasonable compensation is considered too low.

Case Examples:

*The Bureau of Labor Statistics reported the 2024 median pay for a farmer, rancher, and other agricultural manager as $87,980 per year.

**Shareholders can take distributions not subject to self-employment tax

Conclusion

For tax practitioners with farm clients, understanding the advantages of an S Corporation can help save your clients from making costly mistakes. You can add value to your agricultural clients by ensuring they are aware of the benefits of an S corporation and advising them on reasonable compensation requirements.

We’ll be digging deeper into S corporation operating strategies—including SE tax, compensation, and post-C corporation planning—during the online seminar Sept. 25: Farm Tax Playbook: Creating Wins for Clients. Join us to sharpen your strategies and bring more value to your farm clients.

By Ashley Akin, CPA

Sources:

• Advising S Corporation Clients on Reasonable Compensation
• S corporation compensation and medical insurance issues | Internal Revenue Service
• Farmers, Ranchers, and Other Agricultural Managers : Occupational Outlook Handbook: : U.S. Bureau of Labor Statistics
• Farm Sector Income & Finances – Farm Business Income | Economic Research Service