What is “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. 

Note:  The issue of the reasonableness of compensation also can arise in the context of a C corporation.  Salaries and benefits to a C corporation shareholder/employee that is “too high” can bring an IRS challenge that some of the compensation is really disguised dividends.  An “ostensible salary” paid by a closely held C corporation to one of its few shareholders is likely to constitute a disguised dividend where the amount is “in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees.”  Treas. Reg. §1.162-7(b)(1).

“Reasonable compensation” in the context of an S corporation (with a bit of C corporation discussion thrown in) – it’s the topic of today’s post.

Background

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 $147,000 for 2022, 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 $155,100 in 2023.

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 and, if a court determines that the IRS is correct, the penalty is 100 percent of the taxes owed.   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

Over the past decade there have been some significant cases involving the issue of reasonable compensation in the S corporation context.  Some of the prominent ones include:

• David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), cert. den., 568 U.S. 888 (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. 

In early 2021, the U.S. Tax Court issued its opinion in Ward v. Comr., 2021-32.  In Ward, the petitioner conducted her law practice as an S corporation.  She was the sole shareholder.  For the three tax years at issue, the petitioner reported the net profit or loss from the S corporation on her Form 1040.  In addition, for 2011, the S corporation did not treat any of the amount paid to her as wages on Form 941 and did not report any of it as income.  In 2012, the petitioner reported $73,448 in payments as income, but neither she nor the S corporation reported the amounts as wages.  The petitioner conceded that she was an officer of the S corporation.  The IRS asserted that the amounts were wages, and the Tax Court agreed.  The de minimis exception of Treas. Reg. §31.3121(d)-1(b) didn’t apply because, as the sole shareholder, she was performing services for the corporation.  While the S corporation employed an associate attorney, the petitioner could have claimed that some of the firm’s net profit distributed to the petitioner attributable to the associate attorney’s efforts would not be wages.  However, the petitioner provided no evidence of the value that the associate attorney added to the S corporation or whether that value exceeded the associate’s compensation.  Thus, the salary payments reported to the petitioner by the S corporation were reportable as compensation. 

Note:  A side issue in Ward was that the petitioner also had canceled debt income in years when lenders discharged portions of her debt.  She failed to provide sufficient evidence of her assets and liabilities for a solvency determination to be made. 

And…a C Corporation Reasonable Compensation Case

Another recent case on the reasonable compensation issue illustrates that the matter, as indicated above, can also be a concern for C corporations.  In Clary Hood, Inc. v. Comr., T.C. Memo. 2022-15, a married couple were the sole shareholders of a corporation engaged in the construction business that graded and prepared land.  The corporation’s growth was irregular from 2000 on. The principal took a relatively modest salary between 2000 and 2012 but took a big increase in the years 2013 to 2016, ostensibly to compensate for earlier years. The company had an outside consulting firm perform an analysis to determine what the principal's compensation should be.

The IRS challenged the compensation amounts for 2015 and 2016. The Tax Court examined the usual factors considered in such a case including 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 with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; and the salary policy of the taxpayer as to all employees.  On these points, the relevant facts showed that the corporation had revenue of almost $44 million (net revenue of $7 million) in 2015 and $68 million (net revenue of $14 million in 2016.  The principal’s compensation was set at $168,559 with a $5 million bonus in 2015.  A comparable arrangement was established for 2016.  The principal set the compensation of the other four executives, and none of them were compensated in excess of $234,000.  None of them had a bonus exceeding $100,000. 

The Tax Court denied a deduction for the full amount of the compensation.  While certain factors favored the corporation, the factors addressing comparable pay by comparable concerns, the corporation’s shareholder distribution history, the manner of setting compensation, and the principal’s involvement in the corporation’s business were the most relevant and persuasive factors for the Court.  The Tax Court allowed a deduction of no more than $3,681,269 for the 2015 tax year and $1,362,831 for the 2016 tax year.  

In addition, the IRS assessed an accuracy-related penalty for both years. The taxpayer was able to show that he relied in good faith on the advice of the accounting firm and the Tax Court did not sustain the penalty. However, for the second year the corporation could not substantiate its reliance on the outside adviser and was responsible for an accuracy-related penalty under I.R.C. §6662 for 2016. 

Conclusion

The bottom line is that “reasonable compensation” means that is must be reasonable for all of the services the S corporation owner performs for the corporation.  Because there is no safe harbor for reasonable compensation, the best strategy is to research and document reasonable compensation every year.  That will provide a defensible position if the IRS raises questions on audit.