S corporation reasonable compensation.

• Author: Davis, Glen T., Jr.

An ongoing area of focus for the IRS is whether the compensation paid to a shareholder-employee of an S corporation is reasonable. A recent district court decision highlights the employment tax risks to S corporations that are found to have paid unreasonably low compensation to shareholder-employees while making distributions to the same individuals.

The considerations for an S corporation are much different from those of a C corporation. In the case of a closely held C corporation, the IRS is often concerned with whether the compensation paid for personal services rendered by an employee-shareholder is excessive and is being used to avoid a second level of tax in the form of a dividend distribution. In the case of an S corporation, the IRS believes that employee-shareholders, particularly those who provide professional services, have an incentive to draw a minimal salary in order to reduce their payroll tax liability.

These shareholder-employees would prefer to take a tax-free distribution of funds from the S corporation in lieu of withdrawing the funds in the form of additional salary. The employee-shareholder is already paying tax based on his or her marginal ordinary income tax rates, whether or not the S corporation distributes the income to the shareholder. In many cases, the actual distribution does not result in additional federal income tax because the shareholder will have sufficient tax basis in the stock to absorb the distribution. Thus, by seeking to recast compensation as a tax-free distribution from the S corporation, the employee's wages are reduced, income goes down, but taxable income from the S corporation is increased by a comparable amount. The net effect on the shareholder's income is zero or negligible. However, even though taxable income remains the same, there will be less payroll tax liability to the S corporation as well as to the employee-shareholder.

The IRS has the ability to recharacterize distributions to the S corporation employee-shareholder as wages for employment tax purposes. In Rev. Rul. 74-44, the IRS ruled that distributions that two employee-shareholders arranged to receive instead of compensation for services they performed were deemed wages and were therefore subject to FICA, FUTA, and federal income tax withholding. The revenue ruling described a situation in which there was a clear avoidance motive, as distributions were made to compensate the shareholder-employees who received minimal salaries...