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Mastering the Rules of S Corporation Shareholder-Employee Compensation

WEDNESDAY , FEBRUARY 1, 2017, 1:00-2:50 pm Eastern

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• Feb. 1, 2017

Mastering the Rules of S Corporation Shareholder-Employee Compensation

Samuel D. Brotman, Attorney Brotman Law, San Diego sbrotman@sambrotman.com 619-378-3138 Jason Watson, EA, MBA, Managing Partner Watson CPA Group, Colorado Springs, Colo. jason@watsoncpagroup.com 719-387-9800

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

S Corp Reasonable Compensation Agenda

• Origins, IRS Definition – Jason Watson
• Audit Risk – Jason Watson
• Tax Court Points – Jason Watson
• Tax Court Cases, Facts and Results – Samuel

Brotman

• Keys to Reasonable Salary – Samuel Brotman
• Health Insurance, Competing Interests – Jason

Watson

• Questions and Answers

5

Origin of Reasonable Compensation

• IRS Revenue Ruling 74-44.
• 1974 ruling states that dividends paid to employees

who drew no salary were “wages” subject to withholding and employment taxes.

• Holding: “The ‘dividends’ paid to shareholders…were in

lieu of reasonable compensation for their services.”

• Revenue ruling draws the distinction between

compensation and distributions out of the corporation’s earnings and profits.

6

IRS Definition – Fact Sheet 2008-25

• August 2008, not updated since.
• “S corporations should not attempt to avoid paying

employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.”

• “However, if cash or property or the right to receive

cash and property did go to the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.”

• Minor services, investor only.

7

IRS Definition – Fact Sheet 2008-25

(cont.)

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Another source of income? Another W-2 job?
• Dividend history (old school from C Corp days, really distributions)
• Payments to non-shareholder employees
• Clerical versus sales versus managers
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

8

IRS Definition – Fact Sheet 2008-25 (cont.)

• Website

www.irs.gov/uac/Wage-Compensation-for-S- Corporation-Officers

• r using our simple re-direct

www.wcgurl.com/8247

9

S Corp Audit Risk

• Generally, only 0.4% of S Corps are audited for income tax.
• However, according to the Government Accountability

Office (GAO) S corporations that pay little to no wages and have large shareholder distributions account for most IRS examinations in this area. The Treasury Inspector General has given marching orders to the IRS.

• The 1120S line 7 (compensation of officers) can be

compared to line 21 (ordinary business income)

• Also…1040 lists W-2 and K-1 both with EIN and SSNs, and it

easy for the IRS to design a trigger for examination.

• Further, S corporations with one to three shareholders

made up almost all of the compensation underpayments reviewed by the IRS.

10

Tax Court Points

• There are two tests that tax courts have used in the past. In Label

Graphics, Inc. v. Commissioner, Tax Court Memo 1998-343 which was later affirmed by the 9th Circuit Court in 2000, the court came up with-

• The employee’s role in the company.
• A comparison of the compensation paid to similarly situated

employees in similar companies.

• The character and condition of the company.
• Whether a relationship existed between the company and

employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation.

• Whether the compensation was paid pursuant to a (1) structured,

(2) formal, and (3) consistently applied program.

11

Tax Court Points (cont.)

• In Brewer Quality Homes, Inc. v. Commissioner, Tax

Court Memo 2003-200, the court re-iterated several points from another federal court case (Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987))-

• The employee’s qualifications.
• The nature, extent, and scope of the employee’s work.
• Size and complexity of the company.
• Comparison of the employee’s salary with the

company’s gross and net income. Prevailing general economic conditions.

• Comparison of salaries with distributions to

stockholders.

12

Tax Court Points (cont.)

• Brewer Quality Homes, Inc. v. Commissioner, Tax

Court Memo 2003-200 continued…

• Compensation for comparable positions in comparable

concern.

• Salary policy of the company as to all employees.
• Amount of compensation paid to the employee in

previous years.

• Tax court in K & K Veterinary Supply, Inc. v.

Commissioner (Tax Court Memo 2013-84) used the Brewer decision and subsequent criteria to generate “plusses and minuses” for the taxpayer to determine if the salary was reasonable.

13

Reasonable Compensation Cases –

Radtke v. U.S., 895 F.2d 1196 (7th Cir. 1990)

• Dividends paid to sole shareholder who was also sole

employee of his professional corporation were really wages.

• Facts: Lawyer was sole shareholder and sole full time

employee of his professional corp. Took no compensation,

• nly dividends. IRS assessed deficiencies for failing to pay

FICA and FUTA.

• Holding: “We agree with the district court that the payment

to this employee…constituted wages subject to FICA and FUTA contributions. FICA and FUTA broadly define ‘wages’ as ‘all remuneration for employment’ and the Treasury regulations are similarly bound.

15

Reasonable Compensation Cases –

Ulrich v. U.S., 692 F. Supp. 1053 (D. Minn. 1988)

• An offers who renders substantial services is an

employee.

• Facts: Sole shareholder of an accounting corporation

was also the sole director and officer of the

• corporation. All shareholder’s income was dividends

from the corporation.

• Holding: “Under both the weight of the case law and

under the treasury regulations, a corporate officer is to be treated an employee if he renders more than minor services.”

16

Reasonable Compensation Cases –

Spicer Accounting v. U.S., 918 F.2d 90 (1990)

• Facts: Accountant was the only accountant working at his

firm, working an average of 36 hours per week. Accountant and wife each owned 50% of the stock. Accountant was president, treasurer and a director of the corporation. Accountant never took any salary, only dividends. Said he “donated” services to the corporation.

• Law: “The Federal Insurance Contributions Act and Federal

Unemployment Tax Act both define ‘wages’ as ‘all remuneration for employment.’ Treasury Regulations on Employment Taxes and Collection of Income at Tax Source….provide that the form of payment is immaterial, the only relevant factor being whether payments were actually received as compensation for employment.”

17

Reasonable Compensation Cases –

Spicer continued

• What are the takeaways from the Spicer case?
• 1) Dividends received were really wages as they

were “renumeration for employment”

• 2) Was not an independent contractor because

“[the corporation] provided him with supplies and a place to work, and he performed accounting services for no other firm. Moreover, Mr. Spicer’s services were integral to the operation, as he was the only accountant…”

18

Reasonable Compensation Cases –

Davis v. U.S., 1994 U.S. Dist. LEXIS 10725 (D.C. Colo. 1994)

• Facts: Corporation owned by husband and wife,

both officers. Husband worked elsewhere and not involved in the business. Wife performed clerical duties and spent 12 hours on the business per

• month. Her accountant said her services were

worth $8 per hour. The IRS did not challenge the value of the time commitment.

• Holding: Taxpayer wins because government failed

to present evidence challenging her time commitment and the value of her time.

19

Reasonable Compensation Cases –

Veterinary Surgical Consultants v. Commissioner, 117 T.C. 141 (2001)

• Doctor employed full time for Bristol-Myers Squibb.

Doctor spent 33 hours per week on his S Corporation, which loaned out his consulting services to a veterinary

• hospital. All income from S Corporation was from the
• doctor. Doctor performed all administrative tasks and

regular payments were not made to doctor. Rather, doctor withdrew money at his discretion.

• Holding: If an officer performs more than “minor

services” for the corporation, it is not necessary to determine if the officer is a common law employee. Doctor was an employee of the corporation.

20

Reasonable Compensation Cases –

JD & Associates v. U.S., No. 3:04-cv-59 (D.C.N.D. May 19, 2006)

• Facts: Accountant and sole shareholder took a low

salary and big dividends. The government shows by comparables that the salary was two low and what it should be.

• Holding: The Court noted that the principal’s salary

was less than one of the two employee’s salary and just over the salary of the other three employees in subsequent years.

21

Reasonable Compensation Cases –

Watson , P.C. v. U.S., (DC IA 12/23/10)

• No relation to Jason Watson 
• Holding: The court held an S-Corp accounting firm was

liable for additional taxes, interest, and penalties when it classified $24,000 as wages and $203,651 as distributions for one year of income payments it made to its owner. The result itself is not surprising. But, the guidance provided by the court in determining $24,000 was not “reasonable compensation” is helpful.

• Salary was less than shareholder’s living expenses and

no other research was presented that would justify the level of compensation.

22

Reasonable Compensation Cases –

McAlary Ltd. Inc. v. Commissioner (Tax Court Summary Opinion 2013-62)

• IRS hired a valuation expert
• Expert testified that a real estate agent should have

been paid $100,755 salary out of his S-Corp’s net income of $231,454.

• Not bad. He still took home over $130,000 in K-1

income, and avoided self-employment taxes (mainly Medicare) on that portion of his income.

23

The Key to Reasonable Compensation

• Reasonable compensation is based on what the

shareholder-employee does for the corporation.

• The IRS will look at personal services that are

performed by the shareholder-employee. If gross receipts are tied to services performed by the shareholder-employee, the IRS may seek to reclassify payments that are allocated as “profits” to compensation for services that are subject to self-employment tax.

25

The Key to Reasonable Compensation – Part 2

• The IRS will also look at other factors that contribute to

the gross receipts of the S-Corporation including:

• Services of non-shareholder employees, or
• Capital and equipment.
• Other factors that may tie gross receipts to things other than

services performed by the shareholder-employee (i.e. employees that perform non-income producing or administrative functions)

• If the gross receipts and profits come from these

factors, then the IRS will consider it reasonable that the shareholder-employee would receive distributions along with compensations.

26

Other Factors Helpful in Establishing Reasonable Compensation

• Consistency of compensation to shareholder-

employee (including adequate increases)

• Company’s overall financial performance
• Increase in marketing, advertising, or “rainmaking”

functions of the shareholder-employee outside services tied to gross receipts

• Bureau of Labor statistics, Salary.com and Risk

Management Association (RMA) data

27

Other Factors Helpful in Establishing Reasonable Compensation (cont.)

• Business goodwill and other factors that may

contribute to the production of income outside of direct services performed

• For example- in business valuations in divorce

litigation, some states allow for a personal goodwill distinction separately from enterprise goodwill.

• In other words, if the employee-shareholder died

today, would income still be generated? Insurance agent versus real estate agent?

28

Example:

• Larry Lawyer bills at $300 per hour and bills 1000

hours in tax year 2014 for a total gross receipts of $300,000. The net income for the business is $100,000. Larry is the only shareholder-employee and the only income producing employee. He receives 100% of the compensation. What percentage of Larry’s $100,000 should be classified as compensation?

29

Health Insurance Premiums

• > 2% Shareholder
• S Corp pays health insurance premiums
• Premiums are added to Box 1 (Wages) of W-2, not

Box 3 (Social Security) or Box 5 (Medicare)

• Artificial inflation of Box 1 Wages on W-2
• Premiums are then deducted on Form 1040 Line

29, above the line $1 for $1

• Otherwise, Schedule A subject to limitations
• Detailed in IRS Fact Sheet 2008-25

30

HSA and HRA

• > 2% Shareholder
• S Corp makes HSA contribution on behalf of the

employee-shareholder

• Premiums are added to Box 1 (Wages) of W-2, not

Box 3 (Social Security) or Box 5 (Medicare)

• Artificial inflation of Box 1 Wages on W-2
• Contributions are then deducted on Form 1040

Line 25

31

Competing Interests

• Lower salary for savings of FICA taxes
• Higher salary for maximum Social Security benefits
• Higher salary for retirement benefits (401k, SEP

IRA, Defined Benefits Pension, Cash Balance Plans)

• Higher salary to deflect IRS scrutiny (win the conversation

by not having the conversation)

32