S Corporation Reasonable Compensation

Editor: Kevin D. Anderson, CPA, J.D.

S Corporations

An ongoing area of focus for the IRS is whether the compensation paid to a shareholder-employee of an S corporation is reasonable. A recent district court decision highlights the employment tax risks to S corporations that are found to have paid unreasonably low compensation to shareholder-employees while making distributions to the same individuals.

The considerations for an S corporation are much different from those of a C corporation. In the case of a closely held C corporation, the IRS is often concerned with whether the compensation paid for personal services rendered by an employee-shareholder is excessive and is being used to avoid a second level of tax in the form of a dividend distribution. In the case of an S corporation, the IRS believes that employee-shareholders, particularly those who provide professional services, have an incentive to draw a minimal salary in order to reduce their payroll tax liability.

These shareholder-employees would prefer to take a tax-free distribution of funds from the S corporation in lieu of withdrawing the funds in the form of additional salary. The employee-shareholder is already paying tax based on his or her marginal ordinary income tax rates, whether or not the S corporation distributes the income to the shareholder. In many cases, the actual distribution does not result in additional federal income tax because the shareholder will have sufficient tax basis in the stock to absorb the distribution. Thus, by seeking to recast compensation as a tax-free distribution from the S corporation, the employee’s wages are reduced, income goes down, but taxable income from the S corporation is increased by a comparable amount. The net effect on the shareholder’s income is zero or negligible. However, even though taxable income remains the same, there will be less payroll tax liability to the S corporation as well as to the employee-shareholder.

The IRS has the ability to recharacterize distributions to the S corporation employee-shareholder as wages for employment tax purposes. In Rev. Rul. 74-44, the IRS ruled that distributions that two employee-shareholders arranged to receive instead of compensation for services they performed were deemed wages and were therefore subject to FICA, FUTA, and federal income tax withholding. The revenue ruling described a situation in which there was a clear avoidance motive, as distributions were made to compensate the shareholder-employees who received minimal salaries in that year. Several courts have confirmed the IRS’s ability to increase the employment tax obligations of S corporations under this theory. In a recent case, David E. Watson, P.C., No. 4:08-cv-442 (S.D. Iowa 12/23/10), the court similarly ruled in favor of the IRS.

The issue in this case was whether David Watson’s salary paid by the taxpayer, a professional corporation that elected to be taxed as an S corporation, for 2002 and 2003 was reasonable. Watson was the sole shareholder and employee of the professional corporation, and the professional corporation was a member of an accounting firm. Watson was a CPA with more than 20 years of experience who specialized in partnership taxation. During the 2002 and 2003 tax years, he provided accounting services to the related accounting firm through the professional corporation. Watson received only $24,000 in salary subject to the required employment taxes, while he received substantially larger distributions of profits totaling approximately $200,000 and $175,000 in those years.

The district court found that his stated salary of $24,000 for 2002 and 2003 was not reasonable. Based on the specific facts and circumstances, the court found that an annual salary of $91,044 was reasonable, and it therefore reclassified $67,044 in distributions to wages and required the taxpayer to pay employment taxes on the additional salary amounts each year, as well as interest and penalties.

The court set out to obtain comparables for what other businesses paid for similar services after taking into account Watson’s training and experience as a tax professional. The fact that a professional with 20 years of experience was essentially being paid entry-level compensation particularly seemed to influence the court. It concluded that an employee of Watson’s stature, experience, and earning power is clearly worth more than the $24,000 salary actually paid, as seen by the significant profit distributions he took in lieu of salary.

In advising clients, tax practitioners often seek to provide more specific guidance to determine how much compensation an S corporation should pay an employee-shareholder in order to reduce or eliminate the risk of recharacterization of distributions as wages. The IRS has provided some guidance in Fact Sheet 2008-25 (August 2008). In that document, the IRS states that there are no specific guidelines for reasonable compensation within the Code or regulations and that each case is different based on the independent factors as well as the specific nature of the case. However, FS-2008-25 explicitly states that S corporations should treat payments for services to officers as wages and not as distributions of cash and property, unless they perform no or minimal services. Although there is no specific guidance to determine whether compensation is reasonable, the fact sheet lays out the following as factors that the courts have addressed:

• Training and experience;
• Duties and responsibilities;
• Time and effort devoted to the business;
• Dividend history;
• Payments to nonshareholder employees;
• Timing and manner of paying bonuses to key people;
• Payment by comparable businesses for similar services;
• Compensation agreements; and
• The use of a formula to determine compensation.

The Watson decision serves as a reminder that it is important to consider a variety of factors in establishing reasonable compensation levels for shareholder-employees of an S corporation and why it is so important to closely monitor specific facts and circumstances when determining whether a compensation level is reasonable.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.