U is for Unreasonable Compensation.
I don’t love S corporations. I know that my CPA friends love, love them but I don’t. While I agree that they have advantages in terms of flexibility, many shareholders struggle with compliance putting the S status at risk. And even more concerning? The IRS isn’t a fan. And by isn’t a fan, I mean that they’re looking at S corporation returns with increased scrutiny. As a taxpayer, you don’t want that. You don’t want to be in the “maybe I’ll give this return a second look pile.”
S corporations have been on the IRS’ radar for years. In 2005, the IRS launched an investigation into S corporations to determine whether S corporations were in compliance. It was a big concern since, by that time, S corporations were the most common corporate entity, accounting for nearly 60% of all corporate returns filed.
In 2010, a report issued by the Government Accounting Office (GAO) gave taxpayers more reasons to worry that S corporations were increasingly a target or IRS examinations. The GAO found that in 2003 and 2004, S corporations underpaid wages by $24 billion, dodging payroll taxes in the process.
Here’s how the payroll tax issue works in an S corporation: taxpayers who are shareholders in S corporations are subject to payroll taxes (Medicare and Social Security tax) on salaries just like any other employee. However, since S corporations are a pass-through entity, any additional profit passes to the shareholders as income not subject to payroll taxes. And this has been the big selling point of S corporations: avoid payroll taxes (12.4% for Social Security and 2.9% for Medicare). In a small company where all of the money comes out of the same pot, that’s a savings of nearly 15%.
For now, that’s perfectly legal. And this is why so many tax professionals love S corporations for their small business clients. The plan is generally to slash salaries as much as possible and boost the corresponding profit piece which is not subject to payroll taxes.
But here’s the sticking point: the compensation paid to shareholders must be reasonable. Everyone from tax pros to IRS to shareholders seems to disagree as to what is reasonable. I’ve seen CPAs advise that as little as 10% of profits would be a reasonable salary while the IRS wants to push that number close to 100%. It would appear that the answer is somewhere in the middle.
I tend to believe that the “reasonableness” of a salary relies less on percentages and more on facts and circumstances. A lot can go into that equation, such as geographic location, experience, and overhead. It’s reasonable, for example, to expect that an architect in Manhattan will be paid more than an architect in rural North Carolina. It is just as reasonable to assume that a doctor with 20 years of experience would be paid more than one right out of medical school. The courts have generally agreed that the issue of compensation for services versus distribution of profits is a matter purely of fact. Standard Asbestos Mfg. & Insulating Co. v. Comm’r, 276 F.2d 289, 294 (8th Cir. 1960).
A recent 8th Circuit case, Watson v. U.S. (No. 11-1589 (8th Cir. 2/21/12)), tackled this issue again as it related to S corporations and reasonable compensation and reached a similar decision. In Watson, the lower court found (and the 8th Circuit agreed) that when looking at the substance of the transactions (meaning the amounts paid to Watson), that the amount paid out as salary was “unreasonably low compared to other similarly situated accountants.” In short, the 8th Circuit found that the lower court did not err in its determination that Watson’s salary was unreasonable and agreed that it should be adjusted.
I don’t think that this case is an anomaly. I am seeing more and more of this from IRS and I suspect that it will embolden the IRS to more vigorously pursue instances of what it views as “unreasonable compensation.” So, do yourself a favor and be smart. Don’t open yourself up for audit to save a few bucks. If you have an S corporation, make sure that your compensation structure isn’t unreasonable – and paper, paper, paper that file to prove it.
