Reasonable Compensation for Shareholder-Employees of S-Corporations

“Reasonable compensation” for shareholder-employees of S-Corporations is becoming more of a topic of focus for recipients, as well as, how the IRS and the Tax Courts view compensation. This importance will continue to grow as the new Medicare tax on unearned income and other ‘Affordable Care Act’ provisions are implemented starting in 2013.

Generally, shareholder-employees of S-Corporations, refrain from larger payrolls and distribute earnings in the format of tax free distributions. This process basically reclassifies the wages and avoids payroll taxes. The IRS and the Courts have consistently argued that the “reasonable compensation” be higher (or, in some proposals, 100% of a shareholder-employee’s income) thus subjecting more of the taxpayer’s income to payroll taxes. The dichotomy of these positions has created the problem of how to properly measure what compensation is reasonable and what will be acceptable upon examination.

Courts have been very consistent over the last ten to fifteen years in cases in which the president of an S-Corporation was the sole employee who carried out all of the services for the corporation. When these cases have been brought to court due to the fact that the individual was distributing all of his income as dividends and none as wages, the courts have determined that all the income should be subject to payroll taxes.

The recent 2010 case of David E. Watson, P.C., shed some light on to how the government determines “reasonable compensation” for S-Corporations due to the fact that it was one of the first cases in which the shareholder-employee actually did receive some salary. Previous cases were much more egregious as the shareholder-employee would provide no wages. The government won the Watson case by proving that the average salary of someone in Mr. Watson’s position (non-owner director) in a comparable sized CPA firm was much higher than what Mr. Watson was currently receiving in salary. As a result, the Courts subjected the additional income, not originally classified as wages, to payroll and subjected the payroll to payroll type taxes.

As a result of this ruling, shareholders and their advisors can plan for what might be deemed acceptable as “reasonable compensation” by comparing salaries of non-shareholders in similar positions at like sized companies. In issuing this ruling, the Court mentioned several considerations when quantifying reasonable compensation. Besides the comparison of non shareholders who hold similar positions, they include:

• The size and complexities of the business
• The involvement of the taxpayer
• The current economy
• The intent of the taxpayer and business
• The taxpayer’s qualifications
• A comparison between wages and the income of the business
• A comparison of wages with distributions to other stockholders at the firm
• The wages of other employees at the firm
• The wages paid to the taxpayer in previous years

It should be noted that there can be major penalty consequences if it is ruled that a shareholder-employee is not providing himself “reasonable compensation.” The potential penalties the IRS can assess, which can reach up to 25% of the additional taxes, include:

• Failure to file employment tax returns,
• Failure to deposit the taxes timely,
• Negligence penalties.

Should you be concerned about how the Watson Case may affect your S corporation payroll or your personal return, we suggest that you reach out to your Marcum Tax Professional.