Tales from the Tax Court: What is reasonable compensation for S corporation employee-shareholders?

“Reasonable compensation” doesn’t always mean what you think it means

By: Steven Baugh  /  October 16, 2018

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Taxpayers cannot use corporations as their “own personal pocketbook, depositing and withdrawing funds at will.” Doing so can cause issues with the IRS, especially if you’re an S corporation shareholder.

Given their two roles within what can be a small or closely-held corporation, S corporation shareholder-employees are especially vulnerable to IRS claims that they did not deal with their corporations at “arm’s length”; that is, that they exploited their position as shareholders to better their status as employees. The inherent duality of their roles invites the IRS and courts to closely scrutinize disbursements from the company to each shareholder.

An S corporation may deduct only that part of employees’ compensation that is “reasonable.” Shareholder-employees and S corporations cannot avoid payroll taxes by receiving distributions while underpaying themselves for services. Excess distributions could be reclassified as dividends, which aren’t deductible.

Whether S corporation shareholders’ compensation is reasonable is a classic question based on each taxpayer’s unique facts and circumstances. When the S corporation and the IRS don’t agree on what’s reasonable--enter the Tax Court.

Most courts use a six-factor test to determine reasonable compensation

While there’s no bright-line rule for how much compensation counts as reasonable, evolving case law demonstrates what has worked and what hasn’t. Whether compensation is reasonable is a question of fact determined from analysis of a variety of factors which could include:

  1. The employee’s qualifications and role in the company;
  2. Character and condition of the company;
  3. How the employee’s compensation compares with compensation paid by similar companies for similar services;
  4. The company’s overall compensation policies;
  5. The likelihood that an independent investor would be willing to compensate the employee based on dividends and capital growth;
  6. Whether a conflict of interest is present which might permit the company’s disguising of nondeductible corporate distributions as salary.

Depending on which court will hear the appeal, the Tax Court could apply one of many tests, mostly based on these six factors. For example, if an appeal is to be heard in the 7th Circuit Court of Appeals, the Tax Court would apply the “independent investor” test adopted by prior cases in the 7th Circuit. The 9th Circuit applies a five-factor test based on its precedent.

The IRS uses additional factors based on Owensby & Kritikos, Inc.[1] An IRS job aid is also available detailing the factors and providing other considerations for IRS valuation professionals.

The shareholder bears the burden of proof

A disbursement from an S corporation to a shareholder-employee can be characterized in one of four ways:

  • A deductible, reasonable wage;
  • A nondeductible dividend (only if the entity was a C corporation prior to becoming an S corporation);
  • A non-taxed distribution of capital; or
  • A loan.

S corporation shareholder-employees bear the burden of demonstrating to a court that the IRS mischaracterized a disbursement. The IRS’ determination of what constitutes reasonable compensation is presumed correct. The taxpayer must then demonstrate that the compensation was reasonable or that the distribution was for something other than wages. For example, the taxpayer is responsible for demonstrating to a court that a loan existed at the time that the funds were disbursed.

Wage deductibility sometimes motivates S corporations or their shareholder-employees to mischaracterize dividends as wages or, in the alternative, as loans. Shareholders sometimes try to argue that unreasonably high wages were loans to the shareholder or repayment of loans made to the corporation—to avoid the taxes associated with dividends.

Small business owners shouldn’t underpay themselves—especially when they’re the only employee

More than one justifiably proud small business owner has inadvertently fallen on his or her own sword on the topic of reasonable wages. For example, in a 2018 opinion, the Tax Court in Povolny complimented Mr. Polvony in finding that he had “underpaid” himself: “There’s no reason for us to think that the Commissioner’s estimate is unreasonable given Povolny’s decades of real-estate development experience and the fact that he singlehandedly ran three companies, one of which had hundreds of thousands of dollars in receipts and one of which had an international contract. Povolny didn’t contest this estimate. . .” Mr. Povolny paid employment taxes on only $44,000 worth of wages instead of the $195,000 worth of payments that the IRS claimed was all wages for which he owed employment taxes. The fact that Povolny couldn’t show that the wage determination was wrong meant that the court accepted the IRS’ position.

In short, in tooting one’s horn about their businesses, S corporation shareholder-employees sometimes inadvertently support the IRS’ determination of reasonable wages.

Substantial services mean at least some wages must be paid

Most often, the IRS will claim that an S corporation intentionally underpaid a shareholder-employee to avoid employment taxes. The basic idea is that a small business must employ someone to do its work. Thus, one of the first determinations courts must make in these cases is whether an employer-employee relationship exists.[2] The 9th Circuit Court of Appeals rejected Mr. Spicer’s argument that he was exempt from FICA/FUTA taxes because he paid himself only dividends rather than wages. Mr. Spicer was his accounting firm’s president and only accountant and paid himself only in dividends for the 36 hours per week he worked for himself as an accountant. The Court found that Mr. Spicer performed “substantial services” as an employee for his S corporation and as such owed himself a wage. Looking to the substance, not the form, of the disbursement from the S corporation to himself, the Court recharacterized the dividends that Mr. Spicer paid himself as wages and they were subject to FICA and FUTA.

Failing to pay dividends can also be problematic

Because S corporations can deduct wages paid to employees, it can incentivize the corporation to pay less dividends and more wages. The IRS and the Tax Court can recharacterize these overpaid wages as constructive dividends thus reducing the S corporation’s deduction for wages.

S corporation shareholder-employees are well-advised to pay themselves dividends—if doing so is financially prudent. For example, the Owensby court concluded that when a profitable corporation offered no specific reason for failing to pay dividends, this factor weighed in favor of upholding the IRS’ determination that a portion of the shareholder’s “wages” were actually dividends.

Constructive dividends exist if they “create ‘economic gain, benefit, or income to the owner-taxpayer.’” On this basis, once again, S corporation shareholder-employees often do themselves no favors. For example, disbursements misclassified by the shareholder-employee as wages (i.e., unreasonable wages) are quickly reclassified as dividends. Pacific Management Group details a complicated tax avoidance scheme in which funds were extracted from one company and reinvested in another, tax-free. The Tax Court found that these extractions were distributions of profit that created some economic gain, benefit, or income to the shareholder-employee.

The Povolny decision similarly identified a constructive dividend from a series of transfers among corporations. The standard in Povolny was the same, even if it was worded differently: “there was no discernible business reason for . . . the transfer” and some benefit to the shareholder-employee.

Courts highly scrutinize claims that distributions are repayment of loans

Distributions from the S corporation that are actually loans to the shareholder or repayment of a loan from the shareholder are not included in a shareholder-employee’s income. Loans can be made either to the S corporation shareholder-employee or to the S corporation

In Jones, the court determined that the amounts paid to the shareholder were not loans from the company. Generally, “[a] transfer of money is a loan for Federal income tax purposes if, at the time the funds were transferred, the transferee unconditionally intended to repay the money, and the transferor unconditionally intended to secure payment.”[3]

The Jones decision utilized an exhaustive and non-exclusive list of factors which a court may examine to determine whether a distribution is actually a loan:

  • The extent to which the shareholder controls the corporation
  • The earnings and dividend history of the corporation
  • The magnitude of the withdrawals and whether a ceiling existed to limit the amount the corporation advanced
  • How the parties recorded the withdrawals on their books and records,
  • Whether the parties executed notes
  • Whether interest was paid or accrued
  • Whether security was given for the loan
  • Whether there was a set maturity date
  • Whether the corporation ever undertook to force repayment
  • Whether the shareholder was in a position to repay the withdrawals, and
  • Whether there was any indication the shareholder attempted to repay withdrawals.

The Jones decision determined that based on the frequency of his withdrawals from the company’s account and the wide range of amounts withdrawn, the payments to him were not loans.

Compensation plans can help

“Contingent compensation paid under a longstanding, arm’s length agreement will usually be upheld . . .”[4] Owensby dealt with whether an incentive formula was reasonable at the time that the parties entered into the agreement and whether the agreement was negotiated at arm’s length. “For compensation purposes, the shareholder-employee should be treated like all other employees.”[5] The Owensby court found that while the shareholder-employees were operating under an agreement that had not been negotiated at arm’s length because the two shareholder-employees controlled the board of directors at their two corporations. According to the court, the bonuses received by Owensby and his business partner Kritikos were actually disguised dividends, resulting in a lower deduction for wages paid for the S corporation.

At least one taxpayer has been saved by a bonus program that was consistently applied from its inception in 1991 to the time of the Tax Court opinion in 2016.  The Johnson decision found that IRS determination that the bonus formula yielded unreasonable compensation failed when it reviewed the internal consistency of compensation and the fact that the bonuses were paid pursuant to a structured, formal, and consistently applied program. While the case focused on the 9th Circuit’s “independent investor” test, the fact that the incentive program was consistently applied and revenue-based boded well for the shareholder-employees.

Catch-Up Compensation is Allowed

Taxpayers may have a little leeway to underpay hardworking S-Corporation shareholders. For example, an S-Corporation shareholder whose pay is (or was) partly reinvested in the business can later withdraw those funds as “catch-up compensation.” In Thousand Oaks Residential Care Home, the Tax Court found that compensation paid in the current year for prior year services is deductible if “the employee was actually under compensated in prior years and the current payments are intended as compensation for past services.”

The court credited both testimony and annual board meeting minutes which explicitly stated that the S-Corporation shareholder-employee was being paid additional funds to make up for years in which he was underpaid due to insufficient cash flow. However, the Tax Court also found, using factors discussed in this article, that the S-Corporation shareholder-employee’s catch-up compensation was unreasonable, i.e., that the S-Corporation shareholder-employee overpaid himself.

An S-Corporation shareholder’s total compensation for the year in which he or she receives catch-up compensation doesn’t have to be reasonable, but the S-Corporation shareholder’s catch-up compensation and current year compensation must individually be reasonable. As with any compensation plan, good documentation is key to preventing catch-up compensation payments from being recharacterized.

Keep up to date

In order to avoid recharacterization of payments, S corporation shareholder-employees and their tax advisors should review the IRS job aid on reasonable compensation and relevant court decisions.

[1] Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987), aff’g T.C. Memo. 1985-267

[2] Spicer Accounting, Inc. v. U.S, 918 F.2d 90 (9th Cir. 1990)

[3] Jones, TC Memo 1997-400

[4] Owensby

[5] Id.

Author Name

Steven Baugh

Steven Baugh, JD is a former tax law analyst at The Tax Institute. Steven specializes in tax issues related to corporations, partnerships, and gifts & estates.

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