How Much Has S Corp Reasonable Compensation Evolved?

Navigating the complexities of S corporation compensation can be challenging, but HOW.EDU.VN offers expert guidance to ensure compliance and optimize your tax strategy. Understanding reasonable compensation is critical for S corporation shareholder-employees to avoid IRS scrutiny and potential penalties. Leverage our resources to achieve financial clarity and peace of mind with payroll tax implications and shareholder distributions.

1. Understanding S Corporations and Employment Taxes

S corporations, as pass-through entities, generally avoid entity-level taxation, allocating income and attributes to shareholders who report and pay taxes on their personal income tax returns. This structure has historically offered an employment tax advantage over sole proprietorships, partnerships, and LLCs, stemming from Rev. Rul. 59-221, which stipulates that a shareholder’s undistributed share of S corporation income isn’t treated as self-employment income.

1.1 The Employment Tax Landscape

As the need to fund Social Security and Medicare payments has grown, the employment tax burden on employers, employees, and the self-employed has substantially increased. As of recent years, employers pay a percentage of an employee’s wages toward Social Security tax, with employees also contributing through wage withholding. Both employers and employees share the burden of the Medicare tax on all wages, without limitation. Self-employed individuals bear the full responsibility for both Social Security and Medicare taxes on their self-employment income.

1.2 The S Corporation Advantage

The advantage of operating as an S corporation becomes apparent given that S corporation income is not subject to self-employment tax. This creates a strong incentive for shareholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax.

Example 1: A owns 100% of S Corp, an S corporation. A is also S’s president and only employee. S generates $100,000 of taxable income in 2024, before considering A’s compensation. If A draws a $100,000 salary, S’s taxable income will be reduced to zero. A reports $100,000 of wage income on his individual income tax return, and S and A are liable for the necessary payroll taxes.

Example 2: Alternatively, A withdraws $100,000 from S as a distribution rather than a salary. S’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis. By choosing to take a $100,000 distribution rather than a $100,000 salary, S and A have saved a combined amount in payroll taxes.

2. Reasonable Compensation History: Addressing No Salary Taken

The IRS has long challenged attempts by shareholder-employees to minimize compensation in favor of distributions, given the potential employment tax savings. The IRS initiated its crackdown on these perceived abuses in Rev. Rul. 74-44. The ruling imputed the payment of reasonable salaries to an S corporation that paid dividends but no compensation to two shareholders who provided services to the corporation.

2.1 Key Court Cases

An often-cited decision, Radtke, further clarified the IRS’s position on reasonable compensation. The taxpayer was the sole shareholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw dividends. The IRS argued, and the district court agreed, that the dividends represented wages subject to payroll taxes.

The Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer. The taxpayer, Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation, was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SAI’s lone accountant, Spicer performed substantial services, working approximately 36 hours per week. Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder, he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

2.2 Defining an Employee

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that “salary arrangements between closely held corporations and [their] shareholders warrant close scrutiny.” The Ninth Circuit first looked to Sec. 3121(d), which defines an employee for payroll tax purposes in part as “any officer of a corporation.” Because Spicer was the president of SAI, this requirement was easily met. The Ninth Circuit then turned its attention to Regs. Sec. 31.3121(d)-1(b), which provides an exception to employee status for some officers, but only to an officer who “does not perform any services or performs only minor services.”

In arriving at its decision, the Ninth Circuit held that Spicer’s services were substantial. As the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. The Ninth Circuit concluded that distributions paid to Spicer were classified properly as compensation subject to payroll taxes because “a corporation’s sole full-time worker must be treated as an employee.”

2.3 Subsequent Rulings and Reports

A line of nearly identical rulings followed, with one Pennsylvania CPA at the heart of many of the decisions. In Grey, the sole shareholder of an accounting firm took no salary despite rendering significant services, opting instead to withdraw amounts as independent contractor fees. The Tax Court, using the line of reasoning established in Spicer, held that the shareholder was an employee and the accounting firm was liable for payroll taxes on the independent contractor fees.

After its victory in Grey, the IRS zeroed in on the accounting firm’s client list. In all, six of those clients found themselves in front of the Tax Court, defending the reasonableness of their compensation. In each case, shareholder-employees who provided significant services to their S corporation withdrew the entire taxable income of their corporation as distributions, neglecting to take any salary. The Tax Court held that the shareholders were employees and recharacterized the distributions as compensation.

In 2005, the Treasury Inspector General for Tax Administration (TIGTA) issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed critical insights into owner compensation practices.

2.4 Key Findings from TIGTA and GAO Reports

1. Approximately 80% of all S corporations were more than 50% owned by one shareholder, giving that shareholder control in setting his or her compensation.
2. Owners of single-shareholder S corporations paid themselves salaries equaling only 41.5% of the corporation’s profits, down from 47.1% in 1994.
3. There were 36,000 situations in which the sole owners of S corporations generating over $100,000 of income took no salaries. These corporations passed through billions to their owners free from payroll tax.
4. The payroll taxes paid by single-shareholder S corporations were billions less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.

In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance echoed the concerns expressed in the TIGTA findings. The GAO report noted that in prior years, S corporations had underreported their shareholder compensation by billions, with corporations with fewer than three shareholders responsible for nearly all the underreporting.

3. A Rare Defeat for the IRS: The Davis Case

While the IRS has generally been successful in challenging unreasonably low compensation, there have been exceptions. In Davis, a district court held that the shareholder had proven that services provided to a corporation were not substantial, rejecting the IRS’s attempt to recharacterize distributions made to a shareholder of an S corporation as “arbitrary and capricious.”

3.1 The Significance of Limited Services

Davis was the president of the corporation but did not actively participate in its activities. The court found that based on the uncontroverted evidence of the shareholder, she did not provide substantial services to the corporation and met the exception from employee treatment provided for in the Sec. 3121 regulations. This decision confirms that shareholders need not draw a salary provided they render only minimal services to the corporation.

4. JD & Associates and Watson: Determining Reasonable Compensation

In JD & Associates and Watson, the S corporation shareholder-employees involved drew both salaries and distributions. The courts no longer had to determine that the shareholder was an employee; instead, they only had to decide whether the compensation paid was reasonable given the services provided. The opinions in these decisions offer a crucial framework for tax advisors to follow when recommending compensation amounts for S corporation shareholder-employees.

4.1 Key Details from JD & Associates

In JD & Associates, Jeffrey Dahl was the sole shareholder of JDA, an accounting firm taxed as an S corporation. Dahl was a CPA with extensive experience and ran a successful firm. He was responsible for making all the firm’s hiring decisions, paying its bills, maintaining its books and records, preparing its tax returns, and preparing and reviewing tax returns for the firm’s clients. Despite his extensive responsibilities, Dahl drew a salary significantly lower than what the IRS considered reasonable.

The IRS asserted that Dahl’s compensation was unreasonably low, citing his responsibilities as managing partner of the firm. Engaging the services of a certified valuation engineer (the IRS expert), the IRS made its own determination of reasonable compensation for Dahl’s services. The IRS expert used a national survey of financial ratios conducted by Risk Management Association (RMA) and compared the financial ratios of JDA and Dahl to those of accounting firms with comparable asset levels. The IRS expert then normalized Dahl’s compensation by the average officers’ compensation percentages found in the RMA survey and determined his reasonable compensation.

4.2 The Court’s Decision in JD & Associates

The North Dakota District Court condensed factors previously used by the Eighth Circuit to determine reasonable compensation in the C corporation arena into the following three groupings:

1. Employee performance;
2. Salary comparisons; and
3. Company conditions.

The court cited JDA’s after-tax profit as a percentage of sales and concluded that Dahl’s performance as head of JDA was exemplary. The comparison of salaries also evidenced that Dahl’s salary was unreasonable, as he took a salary barely in excess of his subordinate employees and failed to receive a raise despite JDA’s increase in gross receipts. Finally, the conditions of the company dictated higher pay for Dahl. As a small enterprise with few requirements in terms of reinvestment, the court believed there was excess capital for employee compensation, which would allow for a higher salary than Dahl received.

4.3 IRS Fact Sheet 2008-25

After the district court’s decision in JD & Associates, the IRS issued a fact sheet to remind S corporations of the importance of paying reasonable compensation to their shareholder-employees. To aid shareholders in determining a reasonable salary, the IRS summarized the factors considered by the courts in making this determination and advised shareholders to give them careful consideration in establishing their compensation.

4.4 Key Details from Watson

In Watson, David Watson was a CPA, and the sole shareholder and employee of DEWPC, an S corporation, which in turn was a shareholder in LWBJ, a successful accounting firm. Watson typically worked a significant number of hours per week providing tax services to the firm’s clients. As the sole shareholder of DEWPC, Watson set his annual compensation at a fixed amount for both years in question. Watson received distributions from DEWPC that were significantly higher than his salary.

The IRS maintained that Watson’s compensation was unreasonably low based on the services he provided to DEWPC. The IRS engaged the services of the same general engineer used in JD & Associates to determine an amount of reasonable compensation. In doing so, the IRS again sought to determine the health of DEWPC and Watson’s compensation relative to his peers and subordinates. The IRS expert used the RMA annual statement studies to determine that DEWPC was significantly more profitable than comparably sized firms in the accounting field. Using data from Robert Half and a University of Iowa survey, the IRS expert found that individuals in positions subordinate to Watson were paid significantly more in compensation.

To quantify the amount of reasonable compensation, the IRS expert turned to the Management of an Accounting Practice (MAP) survey conducted by the AICPA specific to the Iowa Society of CPAs. The MAP indicated that an average director in a firm the size of DEWPC would realize a certain amount in compensation annually. The IRS expert then determined that, on average, owners such as Watson billed at a rate approximately higher than did a director. The IRS expert grossed up the director compensation to reflect Watson’s ownership interest, resulting in reasonable annual compensation.

4.5 The Court’s Decision in Watson

The district court held in favor of the IRS, concluding that any reasonable person in Watson’s position at such a profitable firm would be expected to earn far more than his stated salary. The court agreed with the IRS that a reasonable salary in both years would be a specified amount; correspondingly, it reclassified a portion of Watson’s distributions in each of those years as compensation, holding DEWPC liable for payroll taxes on the reclassified amounts.

5. Practical Lessons from JD & Associates and Watson

An S corporation should treat a shareholder who provides substantial services to the S corporation as an employee and compensate him or her accordingly. In computing a reasonable salary, tax advisers should take a lesson from JD & Associates and Watson and perform an analysis using various factors.

5.1 Key Factors to Consider

1. Nature of the S Corporation’s Business: The IRS views professional services corporations, such as law, accounting, or consulting firms, as generating profits primarily through the personal efforts of the employees. As a result, a significant portion of the profits should be paid out in compensation rather than distributions.
2. Employee Qualifications, Responsibilities, and Time and Effort Devoted to Business: Understanding the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. A reduced role for a once full-time shareholder-employee may justify a decrease in salary or compensation to less than industry norms. The greater the experience, responsibilities, and effort of the shareholder-employee, the larger the salary that will be required.
3. Compensation Compared with Nonshareholder Employees or Amounts Paid in Prior Years: Shareholder-employees with more responsibilities than the highest paid nonshareholder should logically have a higher wage than the nonshareholder’s wage. If the corporation has enjoyed rising revenues but the shareholder-employee’s salary has not increased, this may indicate that compensation is unreasonably low.
4. What Comparable Businesses Pay for Similar Services: Tax advisers should review basic benchmarking tools from sources such as salary surveys and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared with industry norms.
5. Compensation as a Percentage of Corporate Sales or Profits: Tax advisers should use the financial ratios published in the RMA and industry-specific publications such as the MAP to determine the corporation’s overall profitability and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, advisers should make these comparisons with similarly sized companies within the same geographic region.
6. Compensation Compared with Distributions: While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that an S corporation pay out all profits as compensation.

5.2 Can a Shareholder Forgo Both Salary and Distributions?

The IRS has indicated that there is no requirement that an S corporation pay compensation to a shareholder-employee provided that he or she also forgoes distributions. However, it is prudent advice to encourage a profitable S corporation to start making reasonable salary payments to its shareholder-employees as soon as it has the means to do so.

6. The Future of S Corporation Reasonable Compensation

S corporation reasonable compensation is a critical issue, with potential legislative changes that could impact the employment tax advantage these corporations have long enjoyed. It is likely that the limitation on the amount of Social Security wages subject to payroll tax will continue to increase, with some suggesting that Congress might remove it entirely. If this were to occur, the likelihood of abuse would only increase.

7. Navigating S Corp Compensation: Expert FAQs

Here are answers to frequently asked questions about S corporation compensation:

1. What is considered reasonable compensation for an S corporation shareholder-employee? Reasonable compensation is the amount that would ordinarily be paid for like services by like organizations in like circumstances.
2. How does the IRS determine reasonable compensation? The IRS considers factors such as the employee’s qualifications, the nature of the business, and compensation paid to non-shareholder employees.
3. What happens if an S corporation shareholder-employee’s compensation is deemed unreasonable? The IRS may reclassify distributions as wages, subjecting the corporation to additional payroll taxes and penalties.
4. Can an S corporation shareholder-employee take distributions instead of salary? While distributions are allowed, shareholder-employees must receive reasonable compensation for services rendered.
5. What is the role of industry surveys in determining reasonable compensation? Industry surveys provide benchmarks for salaries in similar positions and help determine if compensation is reasonable.
6. How do the JD & Associates and Watson cases impact S corporation compensation? These cases provide insights into how courts evaluate the reasonableness of compensation.
7. What is the significance of the TIGTA and GAO reports on S corporation compensation? These reports highlight the underreporting of shareholder compensation and the potential for abuse.
8. Can an S corporation shareholder-employee forgo both salary and distributions? It is generally not advisable, as the IRS may scrutinize such arrangements.
9. How can an S corporation minimize the risk of IRS scrutiny regarding compensation? By paying reasonable compensation, documenting the factors considered in determining compensation, and seeking professional advice.
10. What legislative changes could impact S corporation compensation? Proposals to impose self-employment tax on undistributed income could eliminate the employment tax advantage of S corporations.

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8.2 Take Action Today

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