S corporation shareholder compensation: how much is enough?

• Author: Nitti, Tony

S corporation shareholder-employees and their tax advisers often find themselves with differing goals when setting the shareholder-employee's compensation. Typically the shareholder-employee prefers to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with a body of governing authority providing that the shareholder-employee cannot avoid the imposition of payroll taxes by forgoing reasonable compensation. Unfortunately, until recently this governing authority had offered little in terms of how to actually compute reasonable compensation, leaving tax advisers with sparse guidance upon which to rely when recommending salary amounts to their clients.

In late 2010, an Iowa district court decided Watson, (1) a reasonable compensation case that, together with the North Dakota District Court's 2006 decision in JD & Associates, (2) provides the direction tax advisers have been seeking. Watson and JD & Associates shed much-needed light on the methodology the IRS and the courts use to determine reasonable compensation in the S corporation arena, providing an analytical approach tax advisers can follow when guiding their clients.

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S Corporations and Employment Taxes

As pass through entities, S corporations generally do not pay entity-level tax on their taxable income.' Instead, (3) taxable income and other attributes are allocated among the shareholders, who report the items and pay the corresponding tax on their personal income tax returns. (4)

This S corporation flow through income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in Rev. Rul. 59-221, (5) which held that a shareholder's undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes. (6)

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employee's wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security tax--again limited to the first $106,800 of self-employment income--and the 2.9% Medicare tax on all self-employment income.

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. Consider the following examples.

Example 1: A owns 100% of the stock of 5 Corp., an S corporation. A is also S's president and only employee. S generates $100,000 of taxable income in 2011, before considering A's compensation. If A draws a $100,000 salary, S's taxable income will be reduced to zero. A reports $100,000 of wage income on his individual income tax return, and S and A are liable for the necessary payroll taxes. S is required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S withholds $5,650 (5.65% of $100,000) from A's salary toward A's payroll obligation, resulting in a total payroll tax bill of $13,300. Example 2: Alternatively, A withdraws $100,000 from 5 as a distribution rather than a salary. S's taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis. (7) By choosing to take a $100,000 distribution rather than a $100,000 salary, S and A have saved a combined $13,300 in payroll taxes. Reasonable Compensation History: No Salary Taken

In light of these potential employment tax savings, the IRS has long challenged attempts by shareholder-employees to minimize compensation in favor of distributions. The IRS opened its attack on these perceived abuses in Rev. Rul. 74-44. (8) In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid dividends but no compensation to two shareholders who provided services to the corporation.

Fifteen years later, an oft-cited decision further clarified the IRS's position on reasonable compensation. In Radtke. (9) the taxpayer was the sole shareholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in dividends.

The IRS argued, and the district court agreed, that the dividends represented wages subject to payroll taxes, with the court adding, "where the corporation's only director had the corporation pay himself, the only significant employee, no salary for substantial services ... [h]is 'dividends' functioned as remuneration for employment."

Soon after, the Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer. (10) XQ In that case, the taxpayer was Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation. SAI was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SATs lone accountant, Spicer performed substantial services, working approximately 36 hours per week.

Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that "salary arrangements between closely held corporations and [their] shareholders warrant close scrutiny." (11) In an effort to determine if the distributions truly represented remuneration for services, the Ninth Circuit established a line of analysis that would be followed repeatedly in the years to follow.

The Ninth Circuit first looked to Sec. 3121 (d), which defines an employee for payroll tax purposes in part as "any officer of a corporation." (12) Because Spicer was the...