Eighth Circuit Affirms S Corporation Shareholder’s Compensation Was Not Reasonable

The Eighth Circuit affirmed the District Court for the Southern District of Iowa’s decision that an S corporation shareholder’s $24,000 salary was not reasonable compensation and that the $91,044 salary determined by the government’s expert witness was (David E. Watson, P.C., No. 11-1589 (8th Cir. 2/21/12)).

At issue is a common strategy of paying a small salary to an S corporation shareholder providing services to the corporation to minimize the amount of employment taxes that must be paid. In this case, Watson was a CPA with an advanced degree and 20 years’ experience who formed an S corporation that, in turn, became a partner in his accounting firm. Watson was “employed” by his S corporation. In each of the two years involved in the case, 2002 and 2003, Watson received a salary of $24,000 from the S corporation, but also received distributions of $203,651 and $175,470, respectively, that were not subject to Federal Insurance Contributions Act (FICA) taxes.

In challenging the IRS’ determination that an additional amount was subject to FICA, Watson claimed that the IRS’ expert witness (a certified business valuation analyst) was not qualified to provide the testimony that he gave and that the amount determined to be wages was erroneous. The Eighth Circuit concluded that the expert witness was qualified, rejecting Watson’s argument that, when the expert changed his opinion of the value of Watson’s services after reading Watson’s deposition, it showed that the expert was incompetent.

The court then examined Watson’s compensation, explaining that special scrutiny must be given to salaries paid to employees who control a corporation. Watson argued that no statute, rule or regulation required minimum compensation to be paid. According to the Eighth Circuit, however, the issue was not whether some minimum compensation must be paid, but whether the compensation paid was reasonable. Reasonable compensation analyses apply not only when the issue is whether a salary may be deducted as an ordinary and necessary business expense, but also when the issue is whether payments are wages subject to FICA tax.

The Eighth Circuit affirmed the district court’s holding that an additional $67,044 was subject to FICA tax, noting the lower court’s finding that Watson was a very experienced CPA who worked full time at his firm, one of the most successful firms in town (gross earnings over $2 million a year), and that $24,000 was an excessively low salary for someone of his experience and expertise.