One of the services we provide our small business clients is to insure that the payment of reasonable compensation.  No, I don’t mean what they pay their employees (although we do that, as well, when requested).  No, I am talking about the pay they take for themselves- the owners of the S Corporation or an LLC operating as an S corporation.

Our clients all understand that they must pay social security and Medicare taxes on their compensation.  And, since they own the company, that tax bite comes to 15+% of their salary.  (Yes, the tax is 7.65% of their pay, but since all profits accrue to them, the part the company pays on their behalf reduces their dividend by an additional 7.65%.)  So, many of them argue that they want to pay NO salary.   A proposition to which we refuse to provide our assent.

But, some have done so anyway.  Some of them fired us because we would not agree to their idea.  (I admit- we call it utter stupidity.)  And, then these folks found out that the IRS decided that ALL of their net profits were salary.  Which means that they owed 15.3% on their profits- and owed penalties and interest, to boot.

I’ve written about this problem many times.  (Here’s one of the first ones.)   But, given the fact that 40% of all federal collections are from employment (payroll- the Social Security and Medicare) taxes, it’s not surprising that the IRS wants to make sure that everyone receives reasonable compensation.  It keeps the country afloat!

You probably recall that S entities do not pay corporate income taxes.  Instead, all of their profits are funneled to their owners.   Each owner receives a portion of the profits based upon his/her ownership percentages.  The owners pay personal taxes on these ‘flow-through’ dividends.  Given the IRS regulation (RR 59-221), these dividends are not subject to self-employment taxes- as long as the corporation provide reasonable compensation to these owners.

Given this fact (and what I wrote three paragraphs above), it should not surprise you that the IRS produced another ruling (RR 74-44) that stipulated that the IRS can impute payment of reasonable salaries to stockholders should they be impudent enough to only have dividends as their compensation.  The 9^th Circuit Court was one of the first to provide teeth to this ruling, when it declared that “salary arrangements between closely held corporations and its shareholders warrant close scrutiny”.  And, they decided that for a single full-time employee-owner, the compensation must be substantial- including payment for services offered, effort provided, and for corporate management.

(You should note that the IRS has lost a big case- when the shareholder of the firm was not an employee.  In this case (Davis, 1994 WL 542927), only minimal services were proffered by the stockholder to the corporation, so a salary was not required; instead, the flow-through dividends were acceptable as the only compensation.)

But, that did not stop the IRS.  In another case (Dahl), they determined that the firm was 3X more profitable than its peers (via the after-tax profit/net sales ratio) and the stockholder salary was ½ of its peers (salary as percentage of net sales).  As such, they basically tripled the salary for that individual.  The 8^th Circuit Court concurred, and developed three groupings with which one determines reasonable compensation.

1. Employee Performance
2. Salary Comparisons
3. Corporate Conditions

Those are the three factors by which we examine each of our clients’ firms to discern what would be the reasonable compensation.  We also insure that the choice is congruent with the guidance document (actually a warning to S companies) that the IRS produced some 6 years ago.  This guidance suggest factors to be considered include employee qualifications, the scope and extent of work, the size and complexity of the organization, economic conditions, compensation as percentage of gross and net income, compensation/distribution ratio, compensation compared to other employees, prevailing wages, and previous history of compensation.

Since then, two major cases were decided.  The 8^th District affirmed the IRS and a lower court (2010) decision in 2012 in Watson (107 AFTR 2d 2011-305), upholding a much higher compensation than was originally listed on the tax returns provided the IRS (and agreed with the IRS valuation).  This was followed by the US Tax Court decision (McAlary Ltd., Inc. v. Commissioner, TC 2013-62)- with basically the same result.  (Interestingly, the IRS had not converted all the distributions to payroll in this matter; instead, it employed a $ 40 per hour compensation rate.)

By the way, all these cases involved professional services.   And, these are the biggest bugaboos in the IRS bonnet- since so many professional firms have reclassified from C corporations (for which single-owner entities pay a flat 35% tax rate) to shield income from taxes.

And, the IRS has not challenged entities that do not distribute dividends to the shareholder (distributions) and do not pay salaries- but watch out the second it does.

Share this: