FlexPay Payroll Services recently published a quick note on its website concerning David E. Watson P.C. v. U.S. 668 F.3d 1008, 8th Cir., 2/21/12, a taxpayer loss case against the IRS concerning reasonable salaries paid to S-Corp owners [subject to FICA tax] versus reasonable dividends paid to the owners [not subject to FICA tax].
- Excepts from that article are included here and summarize well the “pitfalls”:
There are no hard-and-fast rules for what constitutes reasonable compensation when it comes to your S Corporation, but the IRS more often than not will take your business to court if it believes it has lowered compensation to avoid or lower its tax bill. The courts typically uphold the IRS’s position.
- Tips on Calculating the Right Amount
Several factors may help determine reasonable compensation of employees, including the following:
The employee’s experience and qualifications;
The nature, extent and scope of the employee’s work;
The size and complexity of the business;
General economic conditions;
The company’s general compensation policy;
A comparison of the employee’s compensation to comparable positions at comparable companies in the area;
The relation of the employee’s compensation to the company’s income, and
The relation of the employee’s compensation to shareholder distributions.
Tax Law Background
Typically, an S Corp wants to keep compensation low to minimize federal payroll taxes. For instance, the FICA tax rate in 2014 is 7.65 percent on amounts up to the wage base of $117,000 plus 1.45 percent on amounts above the wage base. Both the employer and the employee must pay the tax.
Conversely, amounts paid out as dividends and certain other types of distributions may be exempt from FICA. This represents a win-win for the employer and employee.
In a recent landmark case, the Eight Circuit Court ruled that the IRS had appropriately recharacterized distributions paid to an S Corp as compensation, resulting in substantial liability for back taxes, penalties and interest (David E. Watson P.C. v. U.S. 668 F.3d 1008, 8th Cir., 2/21/12). The Supreme Court refused to hear an appeal.
That case has emboldened the IRS in its pursuit of S Corp shareholders being paid unreasonably low salaries.
- Facts of Case #1
Fredrick Blodgett is president and sole shareholder of Glass Blocks Unlimited, an S Corp in California selling glass blocks for the real estate industry. He worked full-time for the company. Blodgett reported no salary for either 2007 or 2008, but the firm made distributions to him for those years of $30,844 and $31,644, respectively. The company did not withhold payroll taxes on the distributions.
On its tax returns for the two years in question, the S Corp reported loan repayments to Blodgett of $29,132 and $8,391. It also paid him $21,078 in dividends in 2008.
After auditing the company, the IRS determined that the distributions and loan repayments constituted taxable salary. It assessed penalties and interest on the unpaid payroll taxes.
For its part, Glass Works argued that the recharacterization of salary was unreasonable. It claimed that Blodgett worked a maximum of 20 hours a week and that a reasonable salary for his work was only $15,860, based on information gleaned from salary reporting websites.
Ruling: The Tax Court agreed with the IRS. It said that the salary statistics cited by Glass Blocks reflected amounts paid to various clerks and officers in the wholesale durables business. None of these positions were comparable to the role of president assumed by Blodgett nor did they take into account his capacity as sole shareholder. Thus, the S Corp owed the full amount of the payroll taxes, including the penalty and interest additions (Glass Blocks Unlimited, TC Memo 2013-180).
- Facts of Case #2
With assistance from his accountant, Sean McAlary established a real estate firm as an S Corp in California. He was the only person working for the firm that held a real estate broker’s license.
McAlary managed all aspects of the firm’s operations, including recruiting and supervising sales agents, conducting real estate sales, procuring advertising, purchasing supplies, and maintaining basic books and records. He often worked 12-hour days with few days off.
The real estate firm established an annual compensation for McAlary of $24,000. However, in 2006 he transferred $240,000 from the firm’s account into his own personal account. On its 2006 tax return, the S Corp reported gross receipts of $518,189 and deductions of $286,735, for a net income of $231,454, but it paid zero wages to its head honcho.
Not surprisingly, the IRS said $24,000 was an unreasonable compensation for payroll tax purposes. At trial, its expert witness set a reasonable salary at $100,755, based on the fair market value of McAlary’s services. The S Corp countered by arguing that the $24,000 salary was reasonable when measuring the firm by the tenth percentile of comparable businesses in the same location. The firm also said it should not be liable for any penalties or interest because it had relied in good faith on the advice of its accountant.
Ruling: The Tax Court budged on the compensation issue, but not as much as the firm would have liked. There was no “arm’s length negotiation” to the salary agreement because McAlary was effectively sitting on both sides of the table. But the Court conceded that a salary of $83,200 would be reasonable under the circumstances.
However, there was no such concession on the matter of penalties and interest. Reliance on a tax professional doesn’t completely absolve the firm of its liabilities. Because the firm didn’t investigate the accountant’s credentials or otherwise ensure his credibility, the Tax Court wouldn’t waive any part of the add-ons (McAlary, TC Summary Opinion 2013-62).
Lessons to be learned: The practice of S Corps reducing payroll tax liability by minimizing compensation continues to be a prime concern for the IRS and lawmakers. As tax reform talk heats up in Washington, one widely-discussed measure would negate this strategy by imposing self-employment tax on S Corp profits. In the meantime, business owners can expect extra scrutiny from the IRS regarding their compensation of shareholder-employees, especially in situations similar to these two where the principals are paid zero or minimal compensation.
With the prospect of substantial tax penalties and additions looming, there is a great deal at stake, especially in this current environment where the IRS is on high alert. The recent developments should provide S Corps with plenty of incentive to ensure that shareholder-employees are being paid a reasonable compensation.
I largely agree with the analysis above; however, I am NOT yet ready to ‘abandon ship’ on the use of S-Corporations just because the IRS scrutinizes what constitutes a “reasonable” salary and lawmakers are taking note. Each time we form an S-Corporation, we walk-through with the client a methodology to assist in figuring out what constitutes a “reasonable” salary. Then, if the S-Corp’s owner has a BIG year!, he or she is entitled to take a dividend on profits from his or her own company above and beyond that salary. The thread of what normally results in taxpayer losses in these cases is over-aggressiveness and/or unreasonableness on the part of the taxpayer and/or his or her adviser. Start by asking yourself… if I didn’t own my company, what would another similar company pay me for the services that I perform here? That’s always a good starting point…
For small businesses, I am almost always in favor of using payroll services, life Flex Pay [above], Pay Chex, or Pay Choice or others, to handle your payroll services. I think that you will find its much easier and less expensive than you think… also, you can then focus on running and building your business!