S-Corporations are closely-held corporations that can have one or many owners, but up to 100 shareholders. Businesses can make an election to be taxed as an S-corporation under  U.S. Code, title 26.A, subchapter S of Chapter 1. The owners of S-corporations are called shareholder-employees of S corporation (S-corp owners). S-corp owners receive money from their S-corps in form of wages and distribution.

What is Reasonable Compensation?

S Corp owners must receive a reasonable compensation from S-corporation in form of wages. IRS requires that “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly”.

During audits, IRS may recharacterize the S corporation’s income to wages, if IRS believes that the S-corp owners’ compensation is not reasonable. In such case, the taxpayer will have to pay the payroll taxes on the recharacterized wages plus interest and penalties. There was a court case David E Watson PC vs USA filed in 2012. In this case, IRS disagreed with Watson’s compensation. Watson paid himself $24000 of wages and $375000 of distribution in 2002 and 2003. By decreasing his wages, Watson decreased his payroll taxes. The tax court ruled in favor of IRS and determined that $96000 should have been a reasonable compensation for Watson. Based on the Tax Court’s decision Watson had to pay over $23000 in payroll taxes, penalties, and interest.

IRS defines that reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances”.

What does IRS take in consideration during audits of reasonable compensation?

• S-corp owners’ education (Master’s Degree vs Associate Degree)
• Full time vs Part time
  • Year around full-time position is 2080 hours per year, defined by US Bureau of Labor Statistics
  • Time and affords devoted to business
• Experience: 20 years of work experience vs 2 years
• Job Duties and Responsibilities
• Industry Comparison
• Compensation Agreement
• IRS would like to see the research and documentation how S corp owners determined their reasonable compensation.

Strategies to minimize the risks of distribution’s recharacterization?

IRS does not always address S Corp owners compensation during audits. It is crucial to eliminate red flags to prevent the recharacterization distribution to wages under Revenue Ruling 77:

• Owners’ wages should be larger than their distribution;
• Avoid many transfers between personal and business bank accounts;
• Minimize shareholder loans from the company;
• Nonowner employees wages should be smaller than S-corp owners’ wages;
• Stay consistent;
• Let your accountant know your time devoted to business so it is correctly reflected on the return;
• Hire a third party to help you to determine reasonable compensation.

July 14, 2017

Other good articles to read:

The Top Ten Tax Cases Of 2012, #4: S Corporation Shareholder Reasonable Compensation – How Much Is Enough?