Reasonable Compensation for S Corp

[OldJack]

The IRS doesn't care about distributions, because distributions don't affect taxable income (unless the distributions go above the shareholder's basis). What they do care about is reporting income as S corporation earnings instead of wages assuming the earnings are the result of personal services.

Armando, if you look at every case the IRS has taken to court for reasonable salary it was because the shareholder had taken non-taxable cash distributions instead of salary. No distributions no problem with reasonable salary.

[veritas]

I had a recent audit so I got some schooling. The fact of the matter is the agents are flying by the seat of their pants. I will give you some reasoning for distributions that you might find interesting. The agent proposed a 10% return on the clients investment. He originally proposed using the tax basis which was very low. Then without our arguing he proposed valuing the business with the going concern value which increased the value dramatically. I'm not saying I agreed with his position however it could work to some client's advantage. So for example you have a small business valued at one million would allow a return on investment of 100,000. So let's say the business earned 150,000, by his reasoning 50,000 would be reasonable compensation.

Then again you could use the John Edwards approach. Earn 5 to 6 million a year as a sole prop attorney then incorporate and elect s-corp status. New reasonable salary 500,000. Savings a cool half million in medicare taxes.

[Matt Sova]

Where?

It's incorrect that there's "nothing in the tax law that defines reasonable." The tax code says wages have to be reasonable. Courts define "reasonable" all the time.

Exactly where did you see court cases where the S-Corp owner took a wage (not no wage what-so-ever) and the court defined "reasonable"? Remember this is S-Corp, not C-Corp.

[Armando Beaujolais]

Armando, if you look at every case the IRS has taken to court for reasonable salary it was because the shareholder had taken non-taxable cash distributions instead of salary. No distributions no problem with reasonable salary.

Apologies for aguing semantics. You are correct about the court cases. In those court cases the shareholders were taking out distributions instead of wages. Technically, the fact that they took distributions is not relevant to tax liability because they could have kept the S corp earnings in the corporation, and taken them out tax free later on. But you're correct that in reality, that's not what happens.

[Armando Beaujolais]

Exactly where did you see court cases where the S-Corp owner took a wage (not no wage what-so-ever) and the court defined "reasonable"? Remember this is S-Corp, not C-Corp.

I don't have my stuff in front of me right now, but I'll look for the cases where there was some token amount put on a W2, and a huge amount taken as S corporation earnings. I did mention earlier that in the past the IRS has gone after S corporation shareholder who "paid little or no wages." Maybe for the sake of argument we can agree that a single-member S corporation that earns $100,000 in profit is in the same boat whether they pay zero wages or $5,000 just to file the form.

The real issue here is the conflict between what's "reasonable," and what an S corporation can get away with. The courts have identified criteria such as the reasonable investor test, what the actual profits are, whether the S corp has realized losses or gains in prior years, the service provided by the shareholder, etc., etc. But in reality, the IRS only goes after those who haven't taken anything, or very little, in wages. The court can't rule on an S corporation shareholder who earns $100,000 but only takes $12,000 in wages if that case is never brought to them.

What I'm worried about is the day the IRS actually starts examining these returns instead of just threatening to do so. Look at the catastrophe that occurred many years ago when the IRS decided to get serious about employers who were treating all their employees as independent contractors (most notable courier companies). They threatened, they threatened, but they still let everybody get away with it. Then one day they actually cracked down and put some major companies out of business.

We know the rules. I honestly think this debate is not about what's "reasonable" under the tax law, but what you can get away with. Is it reasonable to take a person who's earning $200,000 a year, make them an S corporation, and then say that their W2 earnings are $20,000 and their corporation earnings are $80,000? No, of course it's not reasonable. Can you get away with it? Yes, for the time being. I'm just more comfortable saying "You can get away with it" than "Those are reasonable wages."

[Skate1968]

I understand that 'reasonable salary' of an officer would generally be somewhere over 50% of profits distributed to shareholder.

But would money loaned from the corp to the shareholder affect this? Might the IRS see an outstanding loan to officer balance as the shareholder trying to get $$ out of the corp without it being taxed? I would think not. I'd think that as long as you accrue a reasonable rate on the loan it would be fine. Right?

I don't think the shareholder loan would have anything to do with the determination of 'reasonable salary.' Right?

[sea-tax]

I understand that 'reasonable salary' of an officer would generally be somewhere over 50% of profits distributed to shareholder.

But would money loaned from the corp to the shareholder affect this? Might the IRS see an outstanding loan to officer balance as the shareholder trying to get $$ out of the corp without it being taxed? I would think not. I'd think that as long as you accrue a reasonable rate on the loan it would be fine. Right?

I don't think the shareholder loan would have anything to do with the determination of 'reasonable salary.' Right?

Sorry misread statement , Loans if drawn up right should be fine it is distributions that you must worry about.
Actually I have seen auditor and heard stories of them taking the distributions and making them reclassify them as payroll.

Had an audit a couple weeks back that the auditor was looking at officer comp. The client had prepared own return for 04 first year.Profit like 100k. had officer comp of 8k distributions of around 30k. The auditor asked what he used to make at previous job . Client stated 80k at microsoft and the auditor said that 80k then is reasonable comp. I arugued that the Microsoft job had nothing to do with the other. in one he was a manager the other he owned a retail biz. Auditor disagreed and said if he needed 80k to live off of before than that was reasonable.

[BOB W]

I would......

....agree, loans should have nothing to do with reasonable salary. Loans of course should have interest assessed, but that is another topic.

[geekgirldany]

Had an audit a couple weeks back that the auditor was looking at officer comp. The client had prepared own return for 04 first year.Profit like 100k. had officer comp of 8k distributions of around 30k. The auditor asked what he used to make at previous job . Client stated 80k at microsoft and the auditor said that 80k then is reasonable comp. I arugued that the Microsoft job had nothing to do with the other. in one he was a manager the other he owned a retail biz. Auditor disagreed and said if he needed 80k to live off of before than that was reasonable.

Interesting I suppose they look at a person's standard of living. Some have a very high standard of living. Others don't.

[veritas]

I believe and I have stated this before the agents are flying by the seat of their pants. They are after high income types.

[sea-tax]

I believe and I have stated this before the agents are flying by the seat of their pants. They are after high income types.

After this last audit I tend to agree with you . I was not left feeling confident in their approach. I can personally tell you that if you get on of these audits , you are in for a fight.

[MomBob]

reasonable comp

What is reasonable compensation for a shareholder in an S Corp?

I'm new to your forum, but think it's great.

My general rule of thumb for reasonable compensation is "What would you pay someone else to do the same job or what would you expect to be paid to to the job?

[Skate1968]

Thanks

... to SeaTax & Bob for your input!

[Skate1968]

Welcome aboard new member, MomBob!

I also think this forum is great. I wish i knew about it years ago. Great to get a second opinion! or maybe a 3rd, 4rth & 5th!

My general rule of thumb for reasonable compensation is "What would you pay someone else to do the same job or what would you expect to be paid to to the job?

That applies to many situations. But like was said earlier this rule doesn't take into the account the corporation that's not profitable. Or in my client's case, not profitable enough to pay himself the full going rate for his services.

[OldJack]

In determining the reasonableness of an officer's salary under Sec. 162(a)(1), the IRS instructs its personnel to refer to the criteria set forth in the Internal Revenue Manual |IRM 4233, Sec. 232.2 (March 11, 1985). The courts have similarly applied these criteria when confronted with the unreasonable compensation issue. |See, e.g., Mayson Manufacturing Co. 178 F2d 115 (CA-6, 1949)) Although the manual specifically addresses the excessive compensation issue, rather than the inadequate compensation issue, factors used to determine reasonable levels of compensation should be equally applicable to both situations.

The fact that the courts have applied these excessive compensation factors to the allocation of income in family owned S corporations where a shareholder-employee was undercompensated supports this position.

By applying the excessive compensation criteria in the reverse, the following factors may be supportive of a lower salary:
* Employee's duties are minimal and undemanding.
* Employee has little or no related work experience.
* Employee possesses no special technical skills or training.
* Employee's time and responsibility requirements are minimal.
* Economic conditions are poor.
* Industry salary levels are comparably low.
* Corporate profits are marginal or declining.
* Salary is authorized and the amount is fixed in advance.
* Salary payments are received regularly throughout the year.