The release of tax returns of presidential candidates has again brought popular media coverage of the issue of what is reasonable compensation for S corporation shareholders.

One of the continuing advantages of the S corporation format over taxation of partnerships and LLCs is the ability to treat a portion of payments from an S corporation as being return on invested capital not subject to employment taxes. Studies continue to indicate that many S corporations are fairly aggressive in the amount of S corporation earnings that are treated as shareholder distributions, rather than employee compensation. There are enough S corporations that assert that none of the S corporation return is compensation that most of the court cases are devoted to that fact pattern, and the Internal Revenue Service always wins.

More typical, however, is the situation with the presidential candidates' returns, where some S corporation return is reported as compensation, but it seems relatively small when looking at other factors, such as the total K-1 return, the amount of capital invested, and the work performed by others for the S corporation.

The issue is likely to become even more significant starting in 2013 with the 0.9 percent increase in Medicare taxes on earned income. A Treasury study several years ago suggested that more-than-50-percent S corporation shareholders be taxed similar to the partnership model, with a presumption that all of their earnings from the S corporation be subject to employment taxes. This proposal has so far not gained wide support either in Congress or even within the IRS.

 

REASONABLE COMPENSATION

Reasonable compensation remains a facts and circumstances test. Some of the factors typically cited for determining reasonable compensation include the training and experience of the shareholder/employee, their duties and responsibilities, and time devoted to the business. Other factors are the S corporation's dividend payment history, payments to non-shareholder employees, and capital invested in the business. Compensation in comparable businesses may be taken into account, as well as compensation agreements and formulas, and patterns of paying bonuses.

If the business is primarily a service business with the services performed by the principal shareholder, the IRS would tend to expect that the majority of the earnings of the business should be treated as compensation. A service business would have relatively less capital and need to accumulate less capital for expansion. A service S corporation with large dividend payouts compared to the amount treated as compensation could be a potential candidate for an IRS audit. This is the No. 1 audit issue facing S corporations, and the comparison between W-2 compensation and K-1 dividends is relatively easy for the IRS to make.

Where an S corp has used compensation comparables with other businesses in the industry, and stable, steady compensation to try to justify relatively low compensation compared to dividends, one issue that sometimes arises is the obligation to pay that compensation in years without profits. In a C corp, compensation is usually paid regardless of profits and it results in increased losses in bad years. Some practitioners feel that to justify the low compensation in an S corp setting, it must even be paid in years when there are no dividend payouts and it increases losses. Others argue that the IRS is primarily comparing the compensation to dividend payouts and no compensation payments are required in years when no dividend payments are made. Such a practice, however, may create more pressure to pay higher compensation in the years when dividend payments are high because one has then lost the stable, steady compensation argument.

Trying to avoid S corporation dividends by making corporate loans to shareholder/employees has been attacked successfully by the IRS. The corporate loans were reclassified as compensation just as dividends might have been reclassified. Paying personal expenses out of corporate accounts can also be viewed as corporate loans in another form and reclassified as compensation. Distributions of assets, rather than cash, can also be reclassified as compensation.

In the end, there are no hard and fast answers as to what is a reasonable compensation. Having a compensation package that was determined using the many factors focused on by the IRS and that is consistently applied would certainly help. S corporation compensation seems to be another one of those tax areas where the pigs can keep getting fat but the hogs get slaughtered. Keeping compensation at a level that at least does not look like a clear winning case to an IRS auditor may result in the auditor focusing compensation attention on the more abusive situation in the next file.

 

IRS AUDIT SUCCESS

The IRS has a lot of incentive to pursue reasonable compensation cases involving S corporations. Even though S corporation payouts either in the form of compensation or dividends are subject to income tax, to the extent that the payout obligation is shifted to compensation, the IRS can not only collect back employment taxes, but can also assert significant penalties exceeding 100 percent of the employment taxes due for failure to timely deposit the taxes, failure to timely file employment tax returns, failure to withhold income taxes on compensation, and even for negligence.

While the IRS tends to take only the most egregious cases to court, it has an excellent record in winning those cases. With little likelihood of the proposals in the Treasury study to treat all S corporation income of more-than-50 percent shareholders as compensation becoming law, the IRS is likely to have to continue to use audits to track down the most abusive situations.

 

SUMMARY

S corporations continue to be a very popular form for doing business, in spite of the statutory restrictions imposed on their set-up and operation, as compared to partnerships and LLCs. A substantial reason for this continued popularity is thought to be the ability to segregate compensation and dividends. Still, S corporations need to approach compensation in a reasonable manner. The IRS has readily at hand the information necessary to focus on the issue, and shareholder compensation is the No. 1 audit issue that S corporations encounter. Once on the IRS radar screen, the IRS has an excellent record of success in pursuing the issue.

By establishing and maintaining a reasonable compensation strategy that can be explained to an IRS auditor with attached documentation, an S corporation is much more likely to be able to benefit from its choice of status, rather than becoming one of the victims of that choice.

 

 

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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