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What's the "Right Amount" of Compensation for
an S Corporation Shareholder/Employee?
The S corporation
has been used by small business owners to avoid payroll taxes, and the IRS knows
it. Here is a case that describes how a CPA got into trouble with his own S
corporation--and how you can avoid the mistakes that were made.
An unpublished 2001 opinion of the U.S. Tax Court provides an important insight
into the issue of "reasonable compensation" when considering a defensible
minimum amount for an S corporation shareholder/employee. Many tax advisors
agree that you can use this opinion as reliable guidance (even though it is not
binding precedent) when planning such compensation. Here's a brief summary of
the relevant facts and the Court's decision.
Wiley Barron, a CPA, formed an S corporation to practice public accounting in
Arkansas. The S corporation made substantial distributions of profits to him,
but treated only $2,000 - - in one quarter during a three-year period - - as
compensation subject to employment taxes. The S corporation was examined for
payroll tax compliance by an IRS "officer/examiner" specially trained to deal
with worker classification and payroll tax issues. She assessed payroll tax
deficiencies to account for reasonable compensation and Wiley appealed to the
U.S. Tax Court, where he represented himself under the Court's small case
procedures.
In its opinion (T.C.Summ. 2001-10), the Tax Court said that Wiley "was the
individual who was solely responsible for making management decisions and for
controlling every facet of (his) business.” He was the only CPA employed by the
corporation, he worked at it pretty much full time, but he didn't pay himself a
salary. Since the general rule is that a corporate officer is an employee [See
Internal Revenue Code Section 3121(d)], it's fairly obvious that Mr. Barron was
using his S corporation to avoid employment tax on his compensation: in this
case, all or part of the S corporation's earnings which were distributed to him.
Mr. Barron is certainly not the first small business owner to use an S
corporation to avoid payroll taxes on his income, and the IRS has aggressively
pursued many of them. Until now, the position of the IRS had been - - and the
Courts had generally agreed - - that the entire amount of S corporation
distributions should be reclassified as compensation.
But the outcome of this particular case is unique and offers guidance for
establishing reasonable compensation at less than total distributions from the S
corporation. The Tax Court agreed with the revenue officer/examiner's proposed
adjustments, which were based on information from Robert Half Associates
regarding what "reasonable compensation" for a CPA of Mr. Barron's training and
experience would be - - in the area of Arkansas where he practiced. That
"reasonable compensation" was in the range of $45,000 to $49,000 for the years
in dispute. Even though the S corporation had distributed from $56,000 to
$83,000 in those years, only the amount of "reasonable compensation" based on
the reliable comparable data was recharacterized as compensation and subjected
to Social Security and Medicare taxes.
You do not have to live with uncertainty on this issue. We can help you
determine reasonable compensation levels for S corporation
shareholder/employees. We have full access to reliable comparable data and a
complete library of federal tax reference material. Please call us to schedule
an appointment.
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