By David M. Kendrick, CPA, MST

The Court of Appeals recently ruled an annual salary of $24,000 combined with an S-corp. dividend distribution of $175,000 did not represent “reasonable compensation” for the owner of a CPA firm.  The court reclassified approximately $67,000 of distributions to wages subject to payroll tax, interest, and penalties!

The IRS is concerned small business S corporation shareholders are not paying their share of payroll taxes.  When owners receive a low salary in proportion to their distributions, the possibility of IRS scrutiny is high. The IRS has indicated that distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts represent reasonable compensation for services rendered to the corporation.
What is Reasonable Compensation?

The definition of “reasonable compensation” cannot be found in the Code or Regulations.  The courts have based their determinations on the facts and circumstances of each case, often focusing on:

• What comparable businesses pay for similar services
• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees performing a similar function
• Timing and manner of paying bonuses to key people
• Compensation agreements
• The use of a formula to determine compensation

Owners can support relatively lower salaries if revenue is generated by employees or the business requires a sizable investment in capital and equipment. However, if you are a single owner providing a majority of your Companies services, you will definitely want to examine your overall compensation package under the above guidelines.

The courts examine what a non-owner employee with comparable job responsibilities working in your general area gets paid. Other factors such as education, special skills and expertise may be considered. Owners do not always have to receive a salary; for instance, if the company has insufficient cash or is not profitable, no salary may be defensible.  However, paying yourself nothing is often considered unreasonable-- after all, who works for free?

Please contact us with all of your compensation questions – we can help you structure your overall compensation in a tax efficient manner with the goal of minimizing IRS scrutiny.