Frequently, owners of C corporations are accused of receiving excessively high compensation amounts, to avoid having profits taxed at both corporate and individual levels. Conversely, S corporation owners may attempt to keep their salaries low to avoid employment taxes on wages.
Strategy: Arrange “reasonable” compensation for services actually rendered. In a case decided by the 8th Circuit early last year, the IRS prevailed when it questioned the amounts paid to the owner of a personal service firm established as an S corporation. (David E. Watson P.C., 668 F.3d 1008, 8th Circ., 2/21/12) Now the U.S. Supreme Court has refused to review the matter. Result: Case closed.
Facts of the case: A CPA in Iowa was the owner and sole employee of an S corp contracted to work exclusively for another firm in which he was a 25% shareholder. In both 2002 and 2003, he was paid $24,000 in stated annual wages. But he also received $200,000 in purported dividends in 2002 and $175,000 in dividends in 2003. While wages are subject to federal employment taxes, S corporation dividends are not.
When the case went to trial, the government’s expert witness established the fair market value of the CPA’s accounting services to be approximately $91,000 per year. The expert relied on several compensation surveys and studies to help form his opinion, taking into account factor such as the absence of any other employees in the S corp.
The 8th Circuit determined that an annual salary of $91,000 would have been a reasonable compensation for the CPA’s services. Accordingly, it sided with the IRS and upheld Social Security and Medicare tax deficiencies, penalties and interest totaling more than $23,000.
Tip: Expect the IRS to continue to take the same approach in other instances involving professional practices organized as S corporations, especially if it appears that the taxpayer has adopted a miniscule salary to reduce employment tax liability.