On July 25, 2005, the IRS announced the launch of a study to assess the reporting compliance of S corporations. The study, carried out under the National Research Program (NRP), will examine 5,000 randomly selected S corporation returns for tax years 2003 and 2004. The results of the NRP study will be used to more accurately gauge the extent to which the income, deductions and credits from S corporations are properly reported and to develop criteria for identifying S corporation returns with the greatest risk of noncompliance.

While the S corporation offers many appealing features, one of the most prominent is the ability of shareholder-employees to manipulate compensation to (a) avoid payroll taxes, (b) reduce income taxes by converting ordinary income into capital gains or by shifting income to family members, or (c) minimize corporate-level taxes. So, as the new NRP study ramps up, it’s probably a good time to look at compensation issues facing S corporations, with emphasis on the ambiguous and often-misunderstood issue of reasonable compensation in the context of the S corporation shareholder-employee.

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What’s “Reasonable Compensation?”

For compensation to be deductible, it must be reasonable for the personal services actually rendered. Pretty straightforward, right? Not exactly; there’s a balancing act involved, and you may need help from your CPA in achieving the “right” balance. Since pass-through income and distributions from an S corporation are not subject to self-employment tax, the IRS is always looking to see if compensation is too low. In such cases, the IRS may recharacterize distributions as compensation, subjecting them to payroll taxes.

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Factors for Determining Reasonable Salaries

There is no rigid set of rules for measuring the reasonableness of compensation. “Reasonable” is not defined in the Internal Revenue Code and the regulations provide only that reasonable compensation is an amount paid for like service by like enterprises under like circumstances. Thus, each situation must be addressed based on its unique facts and circumstances. Case law has provided five factors that tend to be determinative in most reasonable compensation cases.

• The character and financial condition of the corporation.
• The role the shareholder plays in the corporation, including the employee’s position, hours worked, and duties performed.
• The corporation’s compensation policy for all employees and the shareholder’s individual salary history including the corporation’s internal consistency in establishing the shareholder’s salary.
• How the shareholder’s compensation compares with similarly situated employees of similar companies.
• Whether a hypothetical independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation.

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Factors for Determining Reasonable Salaries

No single factor controls, so a combination of the factors must be considered. Furthermore, these factors are not all-inclusive (and may not be given equal weight). Additional factors may be appropriate, depending on the surrounding facts and circumstances.

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Minimizing Compensation to Avoid Payroll Taxes

When examining an S corporation tax return, the IRS will likely scrutinize the compensation paid to shareholder-employees to determine if it is reasonable and, therefore, reflective of the value of services provided to the corporation. Since pass-through income from S corporations increases a shareholder’s stock basis, thereby permitting distributions without additional income or employment taxes, it is usually advantageous for S shareholders to take distributions in lieu of salary. This reduces FICA taxes on both employee and employer, and reduces unemployment taxes as well.

Obviously, the IRS is well aware of this irresistible tax planning idea. After years of indifference, the Service is now making a concerted effort to reduce abuses, real or perceived. Reportedly, some IRS Service Centers have their computers programmed to flag S corporations that report relatively small salaries in relation to distributions.

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Minimizing Compensation to Avoid Payroll Taxes

If compensation is determined to be unreasonably low, a portion of distributions will be recharacterized as compensation. Payroll taxes, interest and, possibly, penalties will be assessed. The good news is all this can be avoided by paying shareholder-employees a salary that just barely meets the criteria for reasonableness, without exceeding it (after all, no one wants to pay more payroll taxes than the law requires). The bad news is that no one can say with certainty where the line is drawn between reasonable and unreasonable compensation. Your guess is as good as anyone else’s, but if it doesn’t match up with the revenue agent’s “guess”, an IRS audit can become a costly experience.

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Conclusion

Scrutiny of shareholder-employee compensation is already high. With the new NRP study, the IRS’s “interest” in this issue is likely to intensify. It is impossible to make a general statement as to what amount of compensation is reasonable because reasonableness must be determined based on the surrounding facts and circumstances. However, in most situations, a wide range of reasonable compensation can be identified based on the five factors discussed above. While taxpayers do not have latitude to simply pick any compensation amount no matter how low or how excessive it may be, they do have the ability to select an amount within the “range of reasonableness” that best suits their tax planning objectives. The better the documentation (e.g., in the corporate minutes) and the greater the business purpose for transactions between the S corporation and its shareholders, the more likely the transaction will withstand IRS attack. In any case, the compensation to the shareholder-employee must be reasonable for the services rendered.

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Miscellaneous provisions

The Act also:

• limited the amount of the cost of an SUV that may be expensed to $25,000, effective for vehicles placed in service after Oct. 22, 2004.
• allows an above-the-line deduction for attorney's fees and court costs incurred in connection with an unlawful discrimination claim.
• excludes certain stock options from employee wages for FICA/FUTA withholding purposes.

Please keep in mind that we’ve described only the highlights of the most important changes in the new law. Give us a call at your earliest convenience for more details on how you may be affected by this important tax legislation.

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