Reasonable Compensation for Subchapter S Corporation Shareholders

The Issue of Reasonable Compensation for Subchapter S Corporation Shareholders is once again Coming to the Forefront.

You’ve heard the discussion ad nauseum about S corporations and reasonable compensation, but now TIGTA is getting involved.

On August 11, TIGTA released a new report on this very issue.  TIGTA reported:

• Less than 1% of all S corporations are being examined by IRS for payroll tax issues.
• When an S corporation is examined, almost half of the time the IRS doesn’t bring up the issue of reasonable compensation during the audit, even when there is only one shareholder, no officer’s compensation is reported and yet the corporation has made tax-free shareholder distributions.

The issue seems to have been made worse by the Tax Cuts and Jobs Act (TCJA).  While this author is seldom critical of TCJA, the fact of the matter is that the qualified business income deduction or QBID, which is based on the net profit of a business in determining its 20% tax deduction, has led to an incentive to reduce wages paid since doing so will increase the net profit of the S corporation, for example, and thereby increase the QBID. While I know that the wages a business pays do come into play in the final QBID calculation for higher income taxpayers, no one can argue that TCJA doesn’t provide another incentive for shareholder/employees to take less wages.

Here at Tax School, we have addressed the issue of reasonable compensation many times. Most recently, in our 2018 University of Illinois Federal Tax Workbook we offered some guidance to help you with your clients in determining what  questions to ask in this area.

In particular, let me quote from page B162 of the workbook:

The amount of compensation for a particular taxpayer that is reasonable is a question of fact and varies depending upon several factors. In an April 2018 reasonable compensation case, the Tax Court summarized the “profusion of possibly relevant facts” that reasonable compensation “caselaw has sprouted,” specifically mentioning several factors courts have looked to in such cases, including the following.

• • The employee’s qualifications
  • The nature, extent, and scope of the employee’s work
  • The size and complexities of the business
  • A comparison of salaries paid with the gross income and the net income
  • The prevailing general economic conditions
  • Comparison of salaries with distributions to stockholders
  • The prevailing rates of compensation for comparable positions in other comparable businesses
  • The salary policy of the taxpayer as to all employees
  • Historical levels of compensation paid to the employee

The numerous and varied factors that have evolved through reasonable compensation litigation indicate that such cases turn on factual analyses on a case-by-case basis. There is no correct amount of S corporation compensation. This makes the determination of reasonable compensation uncertain for S corporation owners.

Generally, compensation is reasonable if it is at least an amount that represents the FMV of the owner’s or employee’s services. In addition to the courts developing a number of factors to review, the IRS provided a summary of key factors in a publication developed for IRS valuation professionals, agents, and field personnel.

These factors coincide, in part, with those noted by the Tax Court, but other important factors are included. The IRS outlined several factors that relate to the following three areas.

1. 1. The owner or employee
   2. The S corporation business
   3. The compensation

The TIGTA report I mentioned earlier would seem to provide us with some breathing room since they concluded the IRS isn’t examining the issue of reasonable compensation. But the fact that they (TIGTA) have brought the issue to light makes me concerned that the IRS will make this an issue going forward in an effort to generate badly needed revenue for the federal coffers.

The TIGTA report wasn’t just looking at huge S corporations, so that’s another reason for my concern. TIGTA did an analysis on S corporation returns filed between 2016 and 2018 where the profit was at least $100,000 (a good number we all can certainly relate to). TIGTA found that 266,095 returns weren’t selected for audit yet TIGTA made an estimate that as much as $25 billion in compensation wasn’t reported, which saved taxpayers (and cost the government) around $3.3 billion in payroll taxes.

I don’t know how TIGTA came up with their analysis, but as I’ve mentioned, it gives me concern for those S corporation shareholder/employees we know aren’t taking enough compensation.

Among all the other items we need to discuss with our clients, this should be certainly near the top of our list.

If your client balks at the notion of increasing their compensation, ask them a simple question: “Would you go to work for someone other than yourself and accept what you receive as your salary?”

In many cases I think we know the answer.

Stay thirsty for knowledge my friends…

By Tom O’Saben, EA