S corp audit Reclass passive income to employment income We disagree

[femery]

These are my points.
1 My guy is semi retired, but bored at home and likes to travel. Indeed, his wife is a travel writer.
2 When he works, he works 3 days a week, 6 hours per day with an hour for lunch. He is scheduled for 750 hours per year. For that work, he paid himself $12,000 per year, $16.00 per hour.
3 He worked 575 hours in 2007. We document travel to the far corners of the world.
4 My guy is the bookkeeper; mostly he pays the bills by writing checks and using credit cards. The bills themselves come from overhead or orders placed by the GM or the Production manager. Otherwise he hangs around making himself useful. He has no other job title than Bookkeeper.
5 He pays the managers less than $13.00 per hour; he pays himself $16.00 per hour. Quite a lot for a QB bookkeeper, I’m thinking, I’ll add a few Craig’s listings for bookkeeper jobs, as addendum to the memo.
6 Were he to pay himself some other number for the actual hours he worked in 2007, it would be rather big.
If he were to pay himself for the hours scheduled he would be paid: $51,200 + $12,000 / 750. = $84.27. If we pay him for the actual hours he worked, it figures to be $109.91. Were this a C corp. audit and he was paying himself to do bookkeeping at this rate, the IRS would be arguing § 162(a)(1) Trade or Business Expenses, to get the wage back to a real bookkeepers wage.
7 To establish his business, he regularly worked 60 and 80 hour work weeks, for years. In 2007, he had a mature professional management team in place and business was good. It was time that he relax and enjoy the fruits of his investment. Hence, a nice passive income for the year.
I’m real disinclined to make any suggestions of paying him more employment wages for fear of violating § 162(a)(1).
Sound good? Any suggestions?

[BHoffman]

femery - Here's my understanding:

If Scorp profits are good and shareholder took drawings and a very minimal salary, the IRS is likely to reclassify some or all of the drawings to salary.

Does your client have an office for his sole use? Is anyone else in the company a check signer? Is your client the only one with the ability to commit the company to contracts? Is your client the sole shareholder and the only officer? Stuff like that will be used against your client.

I would not worry about Sec 162 regarding SCorp officer salary.

You might argue if the drawings they are seeking to reclassify as wages are more than "reasonable" for the position - but they will argue that your client is not just a bookkeeper. You can argue that your client was out of town for many days during the year.

The SCorp return is going to change with the reclassification, and that will help offset the additional FICA tax. By a little or a lot?

IRS is also going the other way - trying to reclassify losses as passive when they feel the owner did not materially participate.

Good luck and please keep us informed.

[femery]

$1.0 m per year sales, large facility, only bookkeeper. Rairly there.

This is a regular company manufacturing products for a special market.

To respond to M. Hoffman’s questions: The GM has checkbook privileges. All managers and the bookkeeper have offices. Both managers regularly enter into contracts on behalf of the company.

Shareholder is paid more than what is paid to bookkeepers around here, but a little less than his managers, I discovered today. He help around the place when he is done with his bookkeeping.

He has no special talents, beyond owning the store for over 25 years.

I think that it is a violation of § 162(a)(1) Trade or Business Expenses, to pay him significantly more than market for the work he is doing. Look at the treatment of a C corp when a single shareholder is paid more than market for his duties. The IRS is all over them to pay the shareholder market and reclass the remainder of her wage as dividends.

Can the IRS have it both ways? I'd say no. What do you say?

[BHoffman]

I say the IRS can try to do whatever it wants It's up to us to offer our best effort at arguing the client's position.

CCorps with excessively high officer compensation will draw an auditor's attention since it can shift income from the higher corporate rate to the lower personal rate. It is also a way to avoid paying dividends, which are double taxed. It wouldn't be often when IRS will argue that a CCorp's officer salary is too low.

SCorps with excessively low officer compensation will also draw an auditor's attention. "Reasonable Compensation" is the rule for SCorp officers, so the trick is to find that amount with a good level of confidence. I've heard that the IRS will likely accept information from somewhere like www.salary.com. It isn't often when IRS will argue that an SCorp officer's salary is too high.

The additional information you received might help. You've determined that the office can run without his presence. You've also determined that your client is receiving at least reasonable pay per hour for his work. Now, the question might be the number of hours. Perhaps you could discuss the amount of time your client spent out of town, as you mentioned he travels extensively. Always best if you can provide some sort of independent verification for your claims - airline ticket receipts, etc.

Have you run the numbers to see how his Scorp return will change, with the higher deduction for officer salaries? What will be the net effect for your client?

Above all, remain calm and businesslike. Might help if you pretend like you are the IRS auditor when preparing your response. What would convince you that the salary taken was reasonable?

Good luck and please keep us informed.

[JON]

Not fun to

argue, but the only difference will be FICA. He has every right to make money as income, not W-2, on every other asset owned by corporation. This includes employees, inventory and the the use of all other buys. That being said I cannot believe the arguement is reclassifying the entire bottom line. They arguement is he should be paid more as the CEO/CFO. It is an arbitrary area you are getting into. You have to show the other duties are performed by employees other than the owner. IRS usually ends up thrying to reconcile some place inbetween with you. It is only in recent years that they even go after FICA adjustments.

I doubt if the owner is only doing QB books accounting will win. If the managers wanted new cars, new pensions and more vacations-would the QB accountant not be able to stop that.

If he is drawing the income in the same amounts at the same times that does not help. I have always thought that should not count as much, but the IRS says salaries are drawn like that.

Good luck.

[BHoffman]

Yep. FICA is where he gets the increase, but won't the SCorp flow-thru taxable profit decrease?