IRS Turns Its Attention to S Corporation Returns Lowballing Shareholder Compensation

While "unreasonable comp cases" historically have involved compensation that is too high (to avoid the double taxation of C corporation earnings), substantial tax advantages can be gained by S corporations paying unreasonably low compensation. One example, shareholders who are in a high-income tax bracket may reduce compensation to increase pass-through income, when children or parents are also shareholders, their increased share of pass-through income may be taxed at a lower marginal rate.

Furthermore, compensation is subject to payroll (Social Security) taxes, while pass-through income is not subject to payroll taxes or to self-employment tax.

Distributions are not subject to payroll or self-employment taxes, either. Since the increased pass-through income resulting from a lower compensation deduction increases each shareholder's stock basis, potentially permitting additional income it can be advantageous to reduce or eliminate salary and withdraw funds via distributions.

The IRS is well aware of these strategies for reducing or eliminating S corporation compensation, particularly the strategy for minimizing salaries to reduce payroll taxes. Reportedly, it has developed filters to identify S corporation returns for audit that appear to have relatively small salaries in relation to profits.

Furthermore, several Tax Court cases, all of which have been affirmed by the Third Circuit, reinforce the IRS's interest in the understatement of S corporation shareholder-employee compensation.

To summarize, the IRS and the courts have made it increasingly clear that distributions to an actively employed S corporation shareholder will be recharacterized as wages subject to payroll taxes if the distributions are actually disguised compensation.

What is Reasonable? No definition of reasonable can be found in the Code, and the regulations merely provide that reasonable compensation is an amount paid for like services by like enterprises under like circumstances. The courts have enumerated a number of factors for determining reasonableness.

• The character and financial condition of the corporation.
• The role the shareholder plays in the corporation, including his or her position, hours worked, and duties performed.
• The corporation's compensation policy for all employees and the shareholder's individual salary history, including the corporation's internal consistency in establishing the shareholder's salary.
• How the compensation compares with similarly situated employees of other companies.
• Whether a hypothetical, independent investor would conclude that there is an adequate return on investment after considering the shareholder's compensation.

• The employee's qualifications.
• The size and complexity of the business.
• A comparison of salaries paid to sales and net income.
• General economic conditions.
• Comparison of salaries to shareholder distributions and retained earnings.
• Compensation paid in prior years.
• The corporation's dividend history.
• Whether the employee and employer dealt at arm's length.
• Whether the employee guaranteed the employer's debt.