IRS Audit Issue – S Corporation Reasonable Compensation

Overview

One of the areas of “low-hanging fruit” for IRS auditors in recent years involves the issue of reasonable compensation in the S corporation context.  Salary that is too low in relation to the services rendered results in the avoidance of payroll taxes.  So, when shareholder-employees take flow-through distributions from the corporation instead of a salary, the distributions are not subject to payroll taxes (i.e., the employer and employee portions of Federal Insurance Contributions Act (FICA) taxes and the employer Federal Unemployment Tax Act (FUTA) tax.  In accordance with Rev. Rul. 59-221, S corporation flow-through income is taxed at the individual level and is (normally) not subject to self-employment tax.  Also, in addition to avoiding FICA and FUTA tax via S corporation distributions, the 0.9% Medicare tax imposed by I.R.C. §3101(b)(2) for high-wage earners (but not on employers) is also avoided by taking income from an S corporation in the form of distributions.  These are the tax incentives for S corporation shareholder-employees to take less salary relative to distributions from the corporation.  With the Social Security wage base set at $118,500 for 2016, setting a shareholder-employee’s compensation beneath that amount with the balance of compensation consisting of dividends can produce significant tax savings.  The savings will likely increase in 2017.  It is currently projected that the Social Security wage base will be $126,000 in 2017.

Who’s an “Employee”?

Most S corporations, particularly those that involve agricultural businesses, have shareholders that perform substantial services for the corporation as officers and otherwise.  In fact, the services don’t have to be substantial.  Indeed, under a Treasury Regulation, the provision of more than minor services for remuneration makes the shareholder an “employee.”  Once, “employee” status is achieved, the IRS views either a low or non-existent salary to a shareholder who is also an officer/employee as an attempt to evade payroll taxes.  If a court determines that the IRS is correct, the late payment penalty is 10 percent.  The penalty on the person responsible for withholding and paying the tax is 100 percent of the taxes owed if the employer fails to pay the tax.  Of course, the burden is on the corporation to establish that the salary amount under question is reasonable.  

Determining Reasonableness

Before 2005, the court cases involved S corporation owners who received all of their compensation in form of dividends.  Most of the pre-2005 cases involved reclassifications on an all-or-nothing basis.  In 2005, the IRS issued a study entitled, “S Corporation Reporting Compliance.”  Now the courts’ focus is on the reasonableness of the compensation in relation to the services provided to the S corporation.  That means each situation is fact-dependent and is based on the type of business the S corporation is engaged in and the amount and value of the services rendered. 

So what are the factors that the IRS examines to determine if reasonable compensation has been paid?  Here’s a list of some of the primary ones:

• The employee’s qualifications;
• the nature, extent, and scope of the employee’s work;
• the size and complexities of the business;
• a comparison of salaries paid;
• the prevailing general economic conditions;
• comparison of salaries with distributions to shareholders;
• the prevailing rates of compensation paid in similar businesses;
• the taxpayer’s salary policy for all employees; and
• in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

According to the IRS, the key to establishing reasonable compensation is determining what the shareholder/employee did for the S corporation.  That means that the IRS looks to the source of the S corporation’s gross receipts. If they came from services of non-shareholder employees, or capital and equipment, then they should not be associated with the shareholder/employee’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation.  Alternatively, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder/employee’s direct generation of gross receipts, the shareholder/employee should also be compensated for administrative work performed for the other income-producing employees or assets.  As applied in the ag context, for example, this means that reasonable compensation for a shareholder/employee in a crop farming operation could differ from that of a shareholder-employee in a livestock operation.

Recent Cases

For those interested in digging into the issue further, I suggest reading the following cases:

• Watson v. Comr., 668 F.3d 1008 (8th Cir. 2012)
• Sean McAlary Ltd., Inc. v. Comr., T.C. Sum. Op. 2013-62
• Glass Blocks Unlimited v. Comr., T.C. Memo. 2013-180
• Scott Singer Installations, Inc. v. Comr., T.C. Memo. 2016-161

Each of these cases provides insight into the common issues associated with the reasonable compensation issue.  The last two also address distributions and loan repayments in the context of reasonable compensation of unprofitable S corporations with one case being a taxpayer victory and the other a taxpayer loss. 

Conclusion

In the context of an S corporation, "reasonable compensation" is defined in terms of the services that the S corporation owner provides on behalf of the S corporation.  There is no safe harbor.  So, close is not good enough.  Do your homework, keep good records and revisit the issue on an annual basis.  If you do that, you will have a much better chance of withstanding an IRS audit if they examine the issue.