Reasonable compensation for S corporation shareholder employees.

• Author: Beavers, James A.

OVER THE PAST FIVE YEARS, A FEW WIDELY noted cases and multiple government reports have made reasonable compensation a key tax issue for S corporations. Two recent Tax Court opinions focusing on reasonable compensation for S corporation shareholder-employees provide important takeaways for owners and practitioners by addressing common issues surrounding distributions and loan repayments in the context of reasonable compensation.

Background

Secs. 3111 and 3301 require employers to pay FICA and FUTA employment taxes on wages paid to their employees. For federal employment tax purposes, an employee includes any officer of a corporation. An officer who performs more than minor services for a corporation and who receives remuneration in any form for those services is considered an employee whose wages are subject to federal employment taxes (Regs. Sec. 31.3121(d)-1(b)). When an S corporation with a sole owner (as the companies in both cases were) has a portion of its shareholder distributions reclassified as wages, there is not necessarily an unfavorable net income tax effect. The wages represent taxable income to the shareholder, but the wages and employer's payroll taxes are deductible expenses of the company. The problem lies in the payroll taxes clue and, more significantly, in the relatively substantial penalties assessed by the government for failure to deposit payroll taxes and failure to file payroll returns.

Glass Blocks Unlimited

In Glass Blocks Unlimited, an S corporation made payments totaling $62,488 to its sole shareholder over the two-year period at issue. The company reported a portion of the payments as dividend distributions and a portion as repayment of shareholder loans. It did not report any compensation to the shareholder, even though he worked more than 40 hours per week and performed a majority of the roles within the company. The IRS contended that all of the payments to the shareholder represented wages and assessed a payroll tax deficiency of $9,560 plus $3,605 in additions to tax under Sec. 6651(a)(1) and penalties under Sec. 6656. In disputing the tax and penalties, the S corporation raised two arguments. Other S corporations with similar circumstances should note the Tax Court's analyses of these arguments.

The company agreed that the sole shareholder was an employee during the years at issue. However, in these years the shareholder transferred funds to the company to sustain its operations during an economic...