S Corporations – Reasonable Compensation Wages V Distributions

In recent months there have been numerous IRS Revenue Rulings and Tax Court case rulings related to reasonable compensation for shareholder-employees of S corporations. Based upon this activity, it is evident that the IRS is continuing their efforts to further scrutinize what will be considered “reasonable compensation.”

Per IRS rules and regulations, S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.

The IRS will take the position that distributions and other payments by an S corporation to its corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation. (The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.) While there are no specific guidelines for “reasonable compensation” in the Tax Code or the Regulations, various courts have ruled on this issue and have based their determinations solely on the individual facts and circumstances of each case.

The issue of unreasonably low salary payments to S corporation shareholder-employees has been a chief audit concern of the IRS in recent years. Unreasonable compensation is always a matter of facts and circumstances, so any salary to an S corporation shareholder-employee that is below a reasonable amount is a red flag to the IRS. For this reason, any salary to a shareholder-employee below a reasonable amount is subject to IRS scrutiny. In these cases, the IRS attempts to re-characterize dividends/distributions as salary if the amounts were, in fact, paid to the shareholders for services rendered to the corporation.

Listed below, are several factors the IRS considers when determining a reasonable compensation case:

1. Employee’s qualifications
2. The nature, extent, and scope of the employee’s work;
3. Comparison of salaries with distributions to stockholders;
4. Size and complexities of the business;
5. Comparison of the salaries paid with the gross income and the net income of the business;
6. The prevailing general economic conditions;
7. Prevailing rates of compensation for comparable positions and comparable businesses;
8. Salary policy of the taxpayer for all employees;
9. Compensation paid to the particular employee in prior years where the business is a closely-held corporation

If pursuant to examination, it is deemed that the distribution is actually compensation, the IRS will also impose total FICA and FUTA taxes on the amounts re-characterized. It is also likely that the Service will impose penalties for not filing employment tax returns (Forms 940 and 941), late deposit of employment taxes, and for failure to withhold income taxes. The IRS may also impose a 20% negligence penalty if it is determined that the actions of the corporation are due to a “failure to make a reasonable attempt to comply with the provisions” of the Tax Code or to any “careless, reckless, or intentional disregard” of the rules and regulations.

In conclusion, the IRS has been, and will, continue to target these “income tricks.” Taxpayers need to be advised that when determining reasonable compensation, it is best to examine the individual facts and circumstances. There should be a logical rationale for the pay level set for those sole shareholder-employees and it is imperative to understand the possible tax ramifications should these issues be further examined by the IRS.

Your Marcum LLP Tax Advisor can assist you in assessing an appropriate level of compensation.