New 1099-NEC Form
Beginning with tax year 2020, IRS requires to use a new 1099-NEC form to report non-employee compensation—currently defined as payments to individuals not on payroll, but on a contract basis. This includes all independent contractors, gig workers, or self-employed individuals who previously had their payments reported in box 7 of a 1099Misc Form.
If your business paid a contractor more than $600 in a tax year, you’re required to file Form 1099-NEC. However, if the contractor is a C corporation or S corporation, a 1099-NEC is not required.
Generally, payers must file Form 1099-NEC by January 31. For 2020 tax returns, the due date will be February 1, 2021, because January 31, 2021, is on a Sunday.
Compensation paid to S corporation shareholders
Unlike partners in a partnership or members of an LLC, shareholders of an S corporation that perform services for the company can be treated as an employee. In this case, the corporation pays wages to the shareholder. Any wages paid to the shareholder-employees are subject to FICA and FUTA taxes. On the other hand, under current law, an S corporation shareholder’s share of distributions or undistributed profits is not subject to self-employment tax. Therefore, there is an incentive for the corporation to pay the shareholder or employee with distributions instead of salaries. Congress and the IRS are aware of this situation as well. To prevent this strategy from being used effectively, the IRS will reclassify distributions as salaries and will collect the back FICA and FUTA taxes as well as the penalties and interest related to the late payment.
To prevent the IRS from reclassifying distributions as salary, S corporations should pay their shareholders or employees at least a modest salary. The S corporation will be in a better position to argue that a given salary is adequate, rather than trying to justify why no salary was paid.
S corporations may also tend to understate the compensation paid to a shareholder or employees in order to allocate income to other, lower tax bracket members of the same family. Therefore, items considered by members of the family (whether or not themselves shareholders) may be adjusted by the IRS if it is necessary to reflect reasonable compensation to the shareholders for services rendered or capital furnished to the corporation.
Another reason that S corporations may understate the amount of compensation paid to a shareholder or employees has to do with Social Security benefits. For retirees between ages 62 and 64, there is an earned income threshold limitation at which a taxpayer begins to lose Social Security benefits. If an S corporation pays its shareholder or employee through a distribution, rather than a salary, the shareholder can avoid this limitation. This was the situation in Mason.2 In this case, an individual received a written promise from his family’s S corporation for consulting work he did for the entity. This receipt was determined to be taxable earnings and the taxpayer’s Social Security benefits were reduced accordingly.
In this case, the recipient was not a shareholder. Had he owned shares in the S corporation, part of the payment could have been classified as a return of capital and less of his Social Security benefit would have been permanently lost.