A shareholder-employee’s compensation from an S corporation is often subject to IRS scrutiny because S corporation flow-through income enjoys an employment tax advantage over that of sole proprietorships, partnerships and LLCs. This advantage finds its genesis in Revenue Ruling 59-221, which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.
As employment tax rates have climbed, this advantage of operating as an S corporation has become magnified. Because S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax.
So how does a taxpayer or more likely his advisor determine what is “reasonable compensation” for an owner/employee of an S Corporation?
What’s a Reasonable Salary?
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
For tax advisers, the Eighth Circuit’s decision should reinforce the lessons taken home from the original Watson decision. The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, you should consider the following:
Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.
Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.
Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years. Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was paid a smaller salary than recent college graduates. Clearly, this is not advisable.
What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.
Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisers should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.
Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson re-characterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to re-characterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue.
There has never been a case where the courts have reclassified distributions to salary in excess of the Social Security wage base. This approach makes sense, because once compensation equals the Social Security wage base, the payroll tax savings on the shareholder-employee’s remaining distributions amount only to the 2.9% Medicare tax.
Watson, in many respects, was a precedent-setting case in the S corporation reasonable compensation arena, as it shed much-needed light on the methodology the IRS and the courts will employ to determine an amount of reasonable compensation and thereby provided an analytical approach tax advisers can follow when guiding their clients.