Owner Compensation in an S-Corporation In this case, zero compensation is reasonable. Thank you for this well written article that explains it so clearly! The forty-year history of S corporation reasonable compensation battles between the IRS and taxpayers reads as lopsided as Globetrotters versus Generals, and unfortunately, we ain't the . S-corporation reasonable compensation is one of the most misunderstood concepts in tax law. By Paul S. Hamann & Jack Salewski, CPA, CGMA. Evading taxes by disguising your salary as a distribution could get you serious penalties, on top of a big back-tax bill, if an IRS audit . Reasonable Compensation in S-Corporations. The Short Story The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." Several court cases support the authority of the IRS to . The law says the corporation must pay a "reasonable" salary to the owner if the owner provides services to the business. Joe is the sole owner of an S-corporation. Memo. 1949). Nov 5, 2018. An important early compensation case involving exempt organizations was Mabee Petroleum Corp. v. U.S., 203 F.2d 872 (5th Cir. After expenses, Joe issued himself $175,000 in dividends for the year. The following table is a summary generated from IRS statistics on S corporation tax returns for the 2013 tax year. Starbucks Corporation: The federal de minimis doctrine did not apply to claims for unpaid compensation under state IWC wage orders where a nonexempt employee is required to perform off-the-clock work on a regular basis or as a regular feature of the employee's job, the California Supreme Court held. On May 11, 2016, the Court released its decision in H. W. Johnson, Inc. v. 2016-95), the Tax Court held that compensation paid by a closely held corporation was reasonable and therefore deductible.A review of the details of the case and the court's analysis and findings of facts follow.. The authors provide an overview of the law and how it has been interpreted by the Treasury Department and the courts over the years. The market approach to reasonable compensation compares the S corporation's business with others and then looks at the compensation being paid by those businesses to employees who look like you, the shareholder-employee who is likely the CEO. In this case, reasonable compensation will be more along the lines of $80,000 or higher. One of the bigger cases around reasonable compensation is David E. Watson, P.C., V. United States of America. Here the IRS has issued a warning: fail to pay a . The problem lies in the fact that the IRS will not S Corp taxpayers to forgo "reasonable" compensation. 2012), affirming 107 AFTR 2d 2011-311 (DC IA December 23, 2010), is an unreasonable compensation case in the context of a personal service S corporation.The taxpayer, David E. Watson, graduated from the University of Iowa with a bachelor's degree in business administration and a specialization in accounting. The Corporation appealed the district court's holding. The three major sources are: In addition several court cases support the authority of the IRS to reclassify other forms of payments to wages. The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." Reasonable Compensation is the amount S corporations must . Methodology. One of the tax attributes of an S-Corporation over other forms of tax entities is the ability to reduce the overall tax obligation. This two-hour CPE course will include coverage of how the Tax Cuts and Jobs Act (TCJA) affects decision-making in grey areas, and how to determine the optimum amount of compensation (within a reasonable range) for S corporation shareholder-employees. Long story short, there are significant FICA/Medicare tax savings if a business files as an S Corp instead of a partnership or sole proprietor, so the IRS wants to make sure they are getting . As such, there is a veritable mountain of case law on this issue. The payroll tax impact could . Veterinary Surgical Consultants, P.C. And when the officer gets his salary, he still pays the payroll taxes from the amount that he receives of 6.2% for social security taxes and 1.45% for Medicare taxes and his S-Corporation pays 6.2% for Social Security taxes and 1.45% for . Reasonable compensation remains a facts and circumstances test. Facts of the Case. You probably can't pay yourself, say, $20,000 a year if your top team members make $90,000. However, 3 cases, in the last few years, came forth and provided some insight on the subject. This means employee shareholders are For the second time in 2016, the United States Tax Court (the "Court") has issued a decision involving the application of the independent investor test in considering the issue of reasonable compensation for a C corporation. The S-Corporation allows an owner to reduce their tax responsibility via the compensation package assigned to the owner. The case was brought on behalf of non . Your Salary. According to the instructions on Form 1120S, U.S. Income Tax Return for an S Corporation, "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." The corporation went to the Tax Court and the court ruled that $2.7 million was deductible as reasonable compensation. Sean McAlary Ltd. Inc. v. Commissioner (Tax Court Summary Opinion 2013-62) In a recent tax court case, the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp's net income of $231,454. A quick third tip: do look at what your other employees get paid. In a case of first impression, the Eighth Circuit addressed not only the classification of distributions to a shareholder-employee, but also the quantification of reasonable compensation and the factors to be considered in arriving at such quantification. They had been in business since the 1970s, and in 2002, they sold the main . Prior to its adjudication more than 60 years ago, there was little in the way of standard analyses with respect to reasonable compensation cases. Reasonable Compensation for S Corps. Until lately, the IRS did not offer much clarification on how to determine "reasonable compensation. However, tax court cases have given a pretty good idea of what the IRS and the courts look at in determining the owner's salary. What is reasonable compensation for S Corp shareholders?The IRS and S Corp business owners have long been at odds with how corporate officers should be compensated. S Corporation Reasonable Compensation Tip #3. . In Brief. He disregarded sources and criteria that he used in other cases, and that would have resulted in lower indicated reasonable compensation amounts. In a prior court case, an individual created a law firm in which he was the sole shareholder and owner of the firm. The expert did not consider any of the foregoing factors. The IRS requires that distributions and other payments by an S corporation to a corporate officer must be treated as wages "to the extent the amounts are reasonable compensation for services rendered to the corporation." This means the employee's wages must be reasonable compensation, not cash distributions, payments of personal expenses, or loans. Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject . What made Davis different? Under this common scenario, the shareholder must receive an adequate or reasonable amount of compensation for these services. At the other extreme, if the S Corporation is a construction company with large amounts of capital equipment and many non-shareholder's employees, a case could be made that a reasonable salary could be 20% or less. the IRS states that the courts favor the market approach, but because of challenges in matching . Turning first to the officer compensation issue, the Tax Court . v. U.S. Watson, P.C. However, if the shareholder provides services to the S . Say your 100% owned S corporation will make $200,000 in profit prior to any W-2 wages paid to you. A shareholder in an S corp. who provides services to the corporation wears two hats as both an owner and as an employee. In today's article, I'll fully explain reasonable compensation for S Corporations: what it is, why it's important, and how to do it right. The shareholder's reasonable compensation, the court found, was his fixed salary of $199,200 plus $461,200, for each of four years the shareholder was underpaid. The IRS views unreasonable salaries as disguised dividends, making them nondeductible by C corporations and taxable to the shareholder. Sec. IRC section 162(a)(1) allows a deduction for reasonable compensation for personal services actually rendered. The Court was especially critical of Taxpayer's compensation expert. S Corporation shareholder-employees generally prefer dividend distributions of their profits over compensation because compensation payments are subject to payroll taxes and dividend distributions are not. 2012). This amount was above the $150,000 allowed by the Service and below the $483,154 amount of total compensation paid. He owned his portion of LWBJ through . The Tax Court concluded a reasonable compensation amount for Sharon Wechsler—using its "best judgment"—of $253,154, computed as actual salary paid of $178,154 plus a bonus of $75,000. The problem lies in the fact that the IRS will not S Corp taxpayers to forgo "reasonable" compensation. The takeaway. The compensation that the officer gets can be controlled by the officer himself if it is reasonable. Using an S corporation to reduce self-employment taxes - by splitting the income into a "reasonable compensation" salary and S corp dividends - is a popular strategy that financial advisors recommend to clients in a wide range of businesses. Additionally, in Multi-Pak Corp., the Tax Court held that the compensation paid by the taxpayer's wholly owned corporation for one of the year's in issue (2002) was reasonable, but recharacterized a portion of the compensation paid to the taxpayer in the other year in issue (2003) as a non-deductible dividend distribution because the amount . S-Corporations have long been popular due to their single level of taxation as a pass-through entity and the shareholder's share of the corporation's net income is not considered self-employment earnings, and therefore, not subject to self-employment tax (15.3% in 2020). Other factors are the S corporation's dividend payment history, payments . However, if an established S corporation generates $200,000 per year, an annual compensation payment for a sole shareholder-employee of, for example, $3,000 does not meet the IRS's criteria and is not reasonable. 1.199A-2(b)). Reasonable compensation for S-Corporation shareholder employees. Johnson, Inc., T.C. The Act has intertwined S corporation 'reasonable compensation' with the new Section 199A deduction in that (1) an S corporation deducts reasonable compensation in computing its QBI, but the reasonable compensation does not provide a corresponding increase in the shareholder-employee's QBI, and (2) reasonable compensation constitutes W-2 wages and may increase the W-2 wages . It is a myth that a 50/50 split between distributions and wages, or any other rule of thumb, is regularly accepted by the IRS when auditing S corporations. A quiet storm has been brewing among the U.S. circuit courts of appeal.In the past few years, the Second, Fifth, Sixth, Seventh and Ninth Circuit s were asked to decide whether the compensation paid to certain corporate business owners was reasonable and, therefore, wholly deductible, or whether it should be considered a nondeductible dividend. Describe how to maximize S corporation shareholders' 20% passthrough deduction; Identify and apply a formula to determine the optimum amount of wages to maximize the 20% passthrough deduction; Recognize how to adjust reasonable compensation (within a reasonable range) to maximize the 20% passthrough deduction; Differentiate court cases and how . Take a look at the S corporation acceptance letter. Reasonable compensation is a topic I discuss with clients often. In 2001, in a Tax Court case against a Veterinary Clinic, the Tax Court ruled that an employer cannot avoid federal taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporation's net income rather than wages. This is because S corporation shareholders are allocated their pro rata share of the S corporation's QBI, and the S corporation deducts W-2 wages (which includes reasonable compensation paid to S shareholders), as an expense properly allocable to its trade or business, in calculating its QBI (Regs. The reason is: to reduce payroll taxes. Corporate tax deductions for executive compensation are a contentious topic, governed as they have been by the tax code's nebulous use of the term "reasonable" to limit the amount that may be deducted. A reasonable salary is a must. The reason is: to reduce payroll taxes. . In arriving at a reasonable salary, the IRS and the courts could look at a number of factors, including the nature of the work performed, the success of the business, past salary, comparisons of the employee's salary to those paid by similar . Post-2005 courts cases revolved around determining whether the Reasonable Compensation figure paid to the S Corp owner was 'Reasonable' for the services provided to the S Corp. Three court . The IRS does not define "reasonable compensation". Determining what constitutes reasonable compensation is a long-standing issue for C corporations. 1953). v. U.S., 668 F.3d 1008 (8th Cir. The IRS scrutinizes shareholder-employees who are not "reasonably compensated." Shareholder-employees are corporate officers who contribute significantly the day-to-day business operations. Between 2010 and 2013 a flurry of court cases and IRS enforcement brought the issue of 'What is Reasonable Compensation for a Shareholder-employee of an S Corp' out of the shadows and placed it forefront as a priority issue for CPA's, EA's, Tax and Financial advisors to cover with their clients. Mayson — The Grandfather of Reasonable Compensation Case Law. It now states (as it has for several years) that an owner is required to be paid a reasonable salary. From the IRS website: The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation's gross receipts. In a May 2016 ruling in favor of the taxpayer (H.W. In 2011, employers will pay 6.2% of the first $106,800 of an employee's wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. After an IRS audit, it was determined that Joe's $30,000 salary was unreasonable. Mr. David Watson was the president of an accounting firm, Larson, Watson, Bartling and Jeffer. The Court rejected this suggestion, describing it as "misguided" in that wages paid by Management Corp. did not offset reasonable compensation requirements for the services provided by Taxpayer's corporate officers in their capacities as such to Taxpayer. RCReports synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and our EXCLUSIVE database of wages to accurately assess Reasonable Compensation for S Corp, Small & Closely Held Business Owners. Let's jump right into some numbers first before going through reasonable S Corp salary theory developed from IRS revenue rules and tax court cases. The officer's distributions will then be shifted to account for reasonable compensation, and he or she will be assessed the related employment taxes and penalties. David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. RCReports provides a defensible position to an IRS challenge (for S-Corps), and is an excellent planning and valuation tool. Over the years there have been in the neighborhood of 25 to 30 such cases. In that case, the Fifth Circuit Court of Appeals established the important principle that the payment of reasonable salaries to corporate officers does not create inurement. And that's saying something, considering how mind-numbing U.S. tax laws are. Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the service rendered to the corporation. 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. The issue of reasonable compensation was first raised in a 1917 court case and has, over the intervening years, been the subject of many other contested challenges between the Internal Revenue Service and taxpayers. Instead of a rule of thumb, an actual calculation is required. Your Time. The court determined an annual reasonable compensation amount of $93,000 and reclassified some of the distributions as a salary. . The S-Corp Reasonable Compensation Report synthesizes a proprietary blend of IRS criteria, Court Rulings, geographic data and a database of wages to accurately assess Reasonable Compensation for S-Corp and Small Business Owners. As you likely know, one of the biggest advantages of owning an S Corporation is pass-through taxation. Taking No Salary. Normally, you would take $130,000 as W-2 wages and withdraw the rest as nonwage distributions; the $70,000 of remaining profit flows through to you and your taxable income is only $186,000 ($130,000 W-2 plus $56,000 ($70,000 multiplied by 0.8). But if the S Corp shareholder also provides services, then he or she is considered a shareholder-employee and must be paid reasonable compensation for his or her work, which will be taxed. However, 3 cases, in the last few years, came forth and provided some insight on the subject. 141 (2001). The key, however, is to keep good evidence of why your salary, as low as it might be, is considered a reasonable salary. Logically, if you own and operate an S corporation, you probably should be the highest paid employee. And the IRS frequently attacks owners who receive cash distributions from an S corporation, arguing that the distributions were essentially disguised compensation. The court concluded, on balance, that the shareholder's compensation was not reasonable for the tax year in dispute, and the corporation could not deduct the entire claimed amount. One of the biggest IRS rules for S Corps is that the greater than 2% shareholders MUST TAKE reasonable compensation from the S Corp as a W-2 employee. The IRS requires S Corp shareholder-employees to receive a reasonable employee salary, which it generally defines as at least what other businesses pay for similar services. The S corp. may deduct the shareholder's salary . It used to be that the reason for the cases was the flip side because solely owned companies wanted to pay a high salary in order to avoid the problem with dividends. What constitutes reasonable compensation and how it is treated for federal tax purposes are issues that arise for a wide range of organizations, including closely held C corporations, family businesses and S corporations. In December 2010, an Iowa district court decided Watson, a reasonable compensation case involving an S corporation shareholder-employee. Tax Court Rejects Real Estate Broker's Salary as a Reasonable Wage Unlike a C corporation, which itself pays the tax on its taxable income, an S corporation does not directly pay taxes on its income; instead, its income, losses, deductions, and credits are distributed across its shareholders' individual tax returns on a pro rata basis. Not bad. Ultimately, the district court adopted Ostrovsky's opinion and determined that the reasonable amount of Watson's remuneration for services performed totaled $91,044. Sorry. Naturally the lower the overall tax requirement the more profit generated for the owner(s). While many In another Tax Court case, Thousand Oaks Residential Care Home I Inc. v. Commissioner, a husband and wife were owners of an assisted living facility. As a reminder, a shareholder-employee's compensation from . vs. Commissioner, 117 T.C. Other Approaches: Some CPA's advocate the 1/3, 1/3, 1/3 approach: 1/3 Paid as a shareholder salary Until lately, the IRS did not offer much clarification on how to determine "reasonable compensation. Reasonable Compensation and S Corporations. First, as opposed to dividends, wages paid to the S corporation shareholder are subject to self-employment tax. The definition of "reasonable" will vary . One of the seminal cases in the area of reasonable compensation is Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. The company makes $250,000 a year, and Joe paid himself a salary of $30,000. The IRS usually wins when it challenges an S Corp.'s Reasonable Compensation in court. The IRS determined that a reasonable salary for Joe's position was . Reasonable Compensation • Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation • Several court cases support the authority of the An employee-owner of an S-Corp (Watson, 2012) paid himself $24,000 in salary while the S-Corp paid approximately $200,000 to the employee-owner as a distribution of equity. Therefore, the district court rendered a tax deficiency judgment against DEWPC, which included unpaid employment taxes, penalties, and interest in the amount of $23,431.23. When Reasonable Compensation Must be Determined. Business Summary. The IRS and the courts do not recognize a "rules of thumb" related to reasonable compensation of S corporation shareholders. One case illustrated some of the issues involved in S corporation compensation. In this case from 2010, the plaintiff, David Watson, was a CPA and the only shareholder and employee of an S corporation, that, in turn, was a 25% shareholder in an accounting firm. Watson v. US (DC IA 5/27/2010) A recent district court case indicates that the courts are siding with the Internal Revenue Service in the area of reasonable compensation. In the recent case of Lateesa Ward, TC Memo 2020-32, the Tax Court addressed a regular tax planning and reporting issue - reasonable compensation to an S corporation shareholder.The issue is important for at least a couple of primary reasons. Any compensation the owner receives is subject to FICA tax, which imposes an equivalent burden. Watson, P.C. For S corporations, however, reasonable compensation has been driven more by revenue rulings and case law. The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in qualified business income. The IRS often wins those cases, in full or in part, and may collect penalties. I have recently started using a service called RC Reports which is available to CPA's and Financial Advisers who want to help their closely-held S Corporation clients determine a reasonable salary. The IRS has come out on top in all except one: The Davis Case. At Gedeon Law & CPA, we work with our S corporation clients to evaluate and research the factors the IRS and tax courts look at in determining reasonable compensation. In Fleischer's case, the Tax Court invalidated his efforts to assign and transfer both his . At stake here are the employee's 6.2% Social Security and 1.45% Medicare payroll taxes, the S corporation's matching amounts, the Federal Unemployment Tax, and whatever state . As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. An IRS publication provides insight into how taxpayers can expect the agency to review compensation reported on tax returns - and possibly avoid an audit or tax court . The forty-year history of S corporation reasonable compensation battles between the IRS and taxpayers reads as lopsided as Globetrotters versus Generals, and unfortunately, we ain't the . Reasonable compensation cases have been around for many decades. What is reasonable compensation for S Corporations? 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