Intuit Accountants News Central
S Corporation Officer Compensation: What’s Reasonable?
As the economy has taken a downturn and tax revenues have declined, Congress and the Treasury Department have put the pressure on the IRS to generate additional tax revenues. As a result, the IRS has issued its opinion regarding higher audit enforcement.
One of the areas of high enforcement is reasonable officer compensation for shareholders of Subchapter S Corporations. This topic is on the IRS hot list because, oftentimes, people misinterpret the Internal Revenue Code (IRC) and Treasury regulations. The code and regulations are vague and don’t clearly define reasonable compensation for shareholders. In other instances, shareholders of S Corporations abuse the law in order to generate a tax savings’ benefit. The consequences of misinterpretation or abuse of the law can be quite costly if a business gets under audit for reasonable officer compensation. The liability can add up to be as much as two to three times what would have been due originally – had reasonable compensation been paid.
Although the IRC does not define what constitutes reasonable officer compensation, it does state that shareholders of S Corporations are included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding. The law requires corporate officers (shareholders) who perform services for the corporation, and receive or are entitled to receive payments, to have their compensation considered wages.
In addition, courts have consistently held that officers/shareholders of S Corporations who provide more than minor services to their corporation and receive or are entitled to receive compensation, are considered employees and the payment is considered taxable for federal employment tax purposes. If this is the case, then why is the law vague as it relates to reasonable compensation? The more the gray area in tax law, the easier it is for the IRS to increase audit enforcement and generate new tax revenues during a challenging economic environment – such as the one that we are currently experiencing.
It was January 2010 and tax season had barely begun when my phone rang one morning with a panic stricken client. The client proceeded to tell me that he received a letter from the IRS regarding an audit for his business that was no longer in operation. After a brief conversation with my client, I contacted the agent and discovered that the audit was for employment taxes and, specifically, reasonable officer compensation for the business that was taxed as an S Corporation. The agent provided me a list of documents for my client to gather together and told me to schedule a week for the audit. I was puzzled as to why the agent would schedule a “week” for a simple officer compensation examination and also was concerned about my client possibly having a tax liability for a business that was no longer in operation.
On the day of the audit, the agent arrived at my office with a list of interview questions. He was prepared to conduct the examination and close the case with a whopping tax bill that my client would have to pay. What the agent quickly discovered was that it wasn’t going to be easy for the service to reclassify shareholder distributions to W-2 wages in this particular audit.
Because my client was well prepared and had records substantiating their position for the distributions they received while operating the business, the IRS faced challenges it couldn’t overcome in this case. The IRS took the position that the shareholder didn’t pay reasonable officer compensation because the net profit for the year was $71,000 and the W-2 officer compensation was only $29,000. At first glance, one would agree with the IRS. However, as the audit unfolded, I had several factors identified that I used to provide why the $29,000 of officer compensation was more than reasonable.
First, my client was a hands-off owner working six hours a week on average, and had a full staff including managers who managed the daily operations of the business. In addition, the business was sold in September of the year under audit, which made the $29,000 officer compensation for eight months versus the 12 months the IRS used for their computations.
Furthermore, I provided research done through employment agencies and online job listings documenting what the high-end salary was for an individual in this industry having this particular position. My client was paying an average monthly salary of $3,625 for six hours of services each week, effectively paying officer compensation of $151 per hour. I informed the agent that, based on the facts and circumstances, there were no employment opportunities available in the industry that the client was operating in paying this high of an hourly rate, and that no other company would hire my client or anyone else to do the same job for an hourly rate of $151 per hour, or a salary that equated to that amount.
All the data provided supported our case that my client had paid more than reasonable compensation for the services that were provided to the corporation. The agent determined that this was not an examination that the IRS wanted to pursue any further. Needless to say, we concluded the audit in one day versus the one week that the agent had scheduled.
Although based on the tax return it appeared that the owner didn’t pay reasonable officer compensation, there were other facts and circumstances that the IRS wasn’t aware of that allowed us to support 29%-71% officer compensation/shareholder distribution split. This is not always the case with reasonable compensation examinations. Not all business owners maintain good recordkeeping or have justification for the low amount of officer compensation they pay themselves. In this particular case, had the IRS been able to support its position that the $71,000 of shareholder distributions should have been W-2 wages, my client would have had a tremendous tax liability considering the amount of taxes, penalties and interest that would have been due. If you expect to have a favorable outcome, documentation and substantiation of the distributions and officer compensation is imperative in these types of cases.
Since there are no specific guidelines for reasonable officer compensation outlined in the IRC or the Treasury Regulations, audits can be reviewed on a case by case basis. It is difficult for the IRS to use one case as precedence for future cases because no two business owners operate their business in an identical manner, and no two officers allocate the same number of hours or contribute the same services to their corporation. No two businesses generate the same revenues, so what is reasonable for one business to pay its shareholders may not be reasonable for the other.
The courts that have ruled on reasonable officer compensation cases based their determinations on the facts and circumstances of each case. Nine factors that the courts have considered in providing rulings for reasonable compensation cases include:
- Duties and responsibilities of the shareholder.
- The time and effort the shareholder devotes to the business.
- Training and experience of the shareholder.
- What comparable businesses in the industry pay for similar services.
- Dividend history.
- Payments provided to non-shareholder employees.
- Compensation agreements.
- The timing and manner of paying bonuses to key people in the corporation.
- Any formula used to determine compensation.
In addition, the IRS will consider fringe benefits paid to shareholders as compensation in a reasonable officer compensation audit. For example, health insurance premiums paid on behalf of greater than 2 percent shareholders of S Corporations are considered fringe benefits that are reportable as wages for federal income tax withholding purposes on the shareholders W-2, but are not subject to Social Security and Medicare (FICA), and Federal Unemployment (FUTA) taxes. There are other fringe benefits that can be considered income. However, health insurance is the hottest one at the current time for Congress and the IRS.
I had the great fortune to have a favorable outcome in this particular audit. They don’t all conclude with positive outcomes for our clients, but it does make our job easier in representing reasonable officer compensation examinations when our clients maintain accurate and detailed recordkeeping that we can use to justify why the officer compensation paid was reasonable. Due to the current economic and political landscape, we should expect to see a substantial increase in reasonable compensation audits. This topic is and will continue to be on the forefront of the IRS hot audit list.
I highly recommend that you consult with your clients to review their policies, procedures and recordkeeping, and help them identify what is reasonable for their industry and the services they provide to their corporation. What was reasonable several years ago may not be reasonable today. Perhaps the compensation they paid themselves prior to the recession is too high in today’s marketplace – or maybe not enough if they were not paying reasonable compensation from the get-go.
As the economic and political environment changes, we must also help our clients adapt and make changes that will help them better manage their business and provide some audit protection. Whether this boils down to making changes to officer compensation, providing new avenues for tax savings or simply maintaining better records, we are the professionals who our clients rely on to provide good guidance within the law. Prepare your clients for a potential reasonable officer compensation audit that may come knocking on their door.
You can also visit Andrew's Website
When commenting, please be polite and use the site for your own personal, non-commercial use. For the full legalese of dos and don'ts, see our Online Community Terms of Use. Thanks!
No Comments »
No comments yet.
RSS feed for comments on this post.
Leave a comment
You must be logged in to post a comment.