When we consider the impact of “reasonable compensation,” it is often in relation to wages paid to executives of not-for-profit entities or publicly traded companies. For these entities, if wages are not deemed reasonable compensation because they are too high, the employer can lose a deduction or incur an excise tax. A recent court case underscores a different side of “reasonable compensation” — paying an S-corporation shareholder employee too little in an attempt to avoid employment taxes.
In Watson v U.S., 107 AFTR-2d 2011-305, the taxpayer was a partner in an accounting firm who created an S-corporation, of which he was the sole shareholder. The S-corporation assumed the taxpayer’s partnership interest, and all payments from the partnership were made to the S-corporation. The S-corporation paid the taxpayer a fixed wage, and any additional earnings from the partnership were treated by the S-corporation as dividends. The result of this arrangement was that the taxpayer only paid FICA taxes on the fixed wage, and avoided FICA taxation on the dividends. In one of the years at issue, his total compensation from the partnership approximated $175,000, of which $24,000 was treated as salary by the S-corporation.
The taxpayer arbitrarily set his salary from the S-corporation at $24,000. The pay level did not reflect consideration of the accounting firm’s revenue (approximately $3 million annually), quarterly cash distributions to the S-corporation (each of which exceeded the total annual salary paid to the taxpayer by the S-corporation) or his partnership interest (25%). Additionally, the level of salary from the S-corporation did not have any basis in market research — the IRS’ expert in the case indicated that the salary was less than the minimum reported offer for an accounting graduate in the taxpayer’s home state.
The court held that the salary payment by the S-corporation wasn’t reasonable, and reclassified a significant portion of the S-corporation dividends as wages. The result of this reclassification was that the taxpayer owed additional FICA taxes, as well as penalties and interest.
What can be learned from the taxpayer’s situation in this case? When establishing compensation levels for a shareholder-employee of a corporation, a “business case” for the compensation level should be created; in that way, the taxpayer would have a credible argument to raise in the event of an IRS challenge. Among the methodologies for building this business case are reviewing compensation surveys for similar positions in the geographic area, looking at actual pay by similar employers (available from various sources including government filings), or having a compensation consultant prepare a study.
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