Reasonable Compensation
How the IRS and Tax Court Assess S Corporation Officer/Shareholder/Owner Compensation
S corps are pass-through entities, whereby the IRS does not tax income at the corporate level, but allows income to flow through directly to S corp shareholders. The result is that income is only taxed once on shareholders’ personal tax returns, eliminating the double income tax issue.
The IRS has taken aim at S corp shareholder-employees who report unreasonably low salaries (or even no salary) for the purpose of avoiding employment taxes (Social Security and Medicare). When S corp shareholder-employees adopt the strategy to take distributions from their companies in lieu of salaries, they avoid both income taxes on distributions and employment taxes on unreported compensation.
Under the scenario that these shareholder-employees take $100,000 in distributions rather than a $100,000 salary, they would not pay taxes on distributions and avoid $13,300 of employment taxes.
The Tax Inspector General for Tax Administration and the U.S. Government Accountability Office believe unreported employment taxes of S corp owners can be in the billions of dollars.
In August 2008, the IRS published Fact Sheet FS-2008-25, Wage Compensation for S Corporation Officers. The IRS takes a powerful stance as it writes: “The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.”
While the IRS stakes its claim on what it believes is reasonable compensation, the U.S. Supreme Court’s ruling in Botany Worsted Mills v. United States, 278 U.S. 282 (1929) provided taxpayers the opportunity to defend their claims and present the proof to justify that their compensation is in fact reasonable and that the IRS levy was illegally collected.
This seminal ruling shifted the burden of proof of reasonable compensation to taxpayers to justify their worth. In countless battles between the IRS and corporate shareholders, the various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
In Fact Sheet FS-2008-25, the IRS lists some factors considered by the courts in determining reasonable compensation:
- Training and experience.
- Duties and responsibilities.
- Time and effort devoted to the business.
- Dividend history.
- Payments to non-shareholder employees.
- Timing and manner of paying bonuses to key people.
- What comparable businesses pay for similar services.
- Compensation agreements.
- The use of a formula to determine compensation.
Market-based Compensation
The IRS and courts rely on third-party compensation studies to determine the reasonableness of shareholder-employee compensation. ERI Economic Resource Inc. is a leading compensation data provider that the IRS relies on to determine whether officers’ compensation is in line with compensation of executives at companies within the same industry, geographic region or size.