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December, 2010 Tax Tips and News

Reasonable Compensation – Part 2

There will be no further separate monthly Tax Tip and Tax Newsletter items.  Beginning this month, I will be combining them into a single item of Tax Tips and News.  In addition, you will be receiving a monthly article dealing with resolving tax debts, which is a focal point of my practice.

My October Tax Tip, Reasonable Compensation – Part 1, I dealt with this issue as it relates to owners of C corporations.  (You can access Part 1 under the Tax Tips and News tab in the archived list following the main article). This discussion looks at the issue from the standpoint of S corporation owners, which presents entirely different IRS challenges.

The acceptance letter that the IRS sends to corporations that applied for S corporation status specifically requires that shareholder-employees be paid reasonable compensation for the services they provide. The IRS has increased its interest in this area over the past few years and it is now more likely than ever that salary could become the main thrust of an IRS audit.

Why the big concern?  Unlike C corporations which can be subject to double taxation, S corporations are generally not tax-paying entities.  Rather, their income, deductions, and other attributes flow through to the shareholders who report these items on their personal returns.  The ordinary business income passed through to the owners is not subject to Social Security, Medicare, or federal unemployment taxes.  Salary payments, on the other hand, are subject to these taxes.  Therefore, shareholder-employees can save a significant amount of employment taxes if they paid themselves little or no salary.  As mentioned the IRS has become increasingly aggressive in looking at the salaries paid in relation to the services performed.  If the salaries are deemed too low, the IRS can recharacterize amounts paid in lieu of reasonable compensation as compensation.  In addition to the employment taxes that would result, there are several penalties that would also apply, making the failure to pay reasonable compensation a losing proposition.

What is reasonable compensation?  There are no specific guidelines in the tax code and regulations.  Therefore, the issue arises under audit and, if no agreement is reached, the courts will decide based on the specific facts and circumstances of each case.  The factors the courts have used include training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, what comparable business pay for similar services, compensation agreements, and the use of a formula to determine compensation.  The weight given to these factors varies from business to business.  The question you should ask yourself is: “What would I have to pay someone else to do my job?”  The answer, most likely, would involve an analysis of the factors cited above.

While I am not advocating this as a substitute for performing the requisite due diligence, the closer an employee’s compensation comes to the top wage limit for the social security tax, which is currently $106,800, the better the chances of preventing or prevailing in an audit.  The Social Security tax is 6.2 % each for the employee and employer.  There is no cap on the Medicare tax which is 1.45% each for the employee and employer.

There are ways a qualified tax professional, such as myself, can assist you with a reasonable compensation determination.


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