Reasonable Compensation
IRS focusing more resources on S corporation examinations
By Jim Buttonow, CPA, CITP and Jennifer Villarino, J.D.elect S corporation
(Article courtesy Taxpro Monthly, National Association of Tax Professionals, October, 2013)
Many business owners elect S corporation status to minimize or status to minimize or avoid social security and Medicare taxes. Minimal or no S corporation wages allow an individual shareholder to avoid self-employment taxes and may allow the corporation to avoid payroll taxes. Many S corporations are companies with one shareholder whose compensation is determined unilaterally and not in an arm’s length negotiation. With 60% of the 4.5 million S corporations owned by a single shareholder, the IRS is concerned about S corporation reasonable compensation.
Two recent S corporation compensation cases remind us of the pitfalls and costs of not paying and reporting reasonable compensation to S corporation officers. They also remind us that S corporation reasonable compensation is an active issue in IRS small business examinations.
These cases both involve a single-shareholder business that failed to pay the officer a reasonable wage. The results of these cases were substantial employment tax liabilities and penalties assessed to the employer.
In Glass Blocks Unlimited v.Commissioner, T.C. Memo 2013- 180 (August 7, 2013), the U.S. Tax Court addressed an S corporation officer, Fredrick Blodgett, who made distributions to himself from the S corporation and did not pay himself any wages. Blodgett, as president and sole shareholder, worked full time for the company, a distributor of glass blocks used in construction, and performed all the work in generating more than $1.5 million in revenue over two years.
In these years, Glass Blocks experienced financial difficulties from the real estate downturn and netted less than $10,000 in total ordinary income. Blodgett did not take any wages from Glass Blocks, nor did he report any income other than the S corporation ordinary income reported on his Form 1040 for the two years in question. During the same time period, the S corporation made distributions to Blodgett of more than $62,000, which Glass Blocks characterized as repayment of loans. With little evidence of loan transactions, the IRS took exception, as it often does in similar situations with closely held corporations. The IRS concluded that the payments from Blodgett were capital contributions and not bona fide loans, and the court agreed. The IRS reclassified more than $62,000 as wages.
The court also agreed with the IRS on the assertion of the failure to file and failure to deposit penalties for the S corporation’s now-delinquent Forms 941 for the periods in question. FICA/Medicare taxes and the resulting penalties amounted to a liability of $13,166 to Glass Blocks.
In Sean McAlary Ltd, Inc. v.Commissioner, T.C. Summary Opinion 2013-62 (August 12, 2013), the U.S. Tax Court heard another S corporation reasonable compensation case. McAlary was entering retirement and decided to supplement his income by becoming a real estate broker. In 2003, he set up an S corporation. In 2004, at the advice of his tax preparer, McAlary set up his annual compensation to be a base of $24,000, plus commissions based on the number of associate brokers with whom he could affiliate his real estate company. Similar to Glass Blocks, McAlary was the sole shareholder of the corporation, its only employee, and the only person in the firm who held a real estate license. McAlary worked long days and performed all of the services essential to managing and operating the business. He contracted with associate brokers to generate sales commissions. In 2006, the S corporation made a net income of $231,454, but did not pay McAlary a salary. However, McAlary did receive transfers totaling $240,000 from the corporation to his personal account. On his Form 1040, McAlary did not report wages from any source, nor did he pay any self-employment tax. McAlary did report his ordinary income from the S corporation.
During the trial, the IRS presented a valuation expert who deemed reasonable compensation to be $100,755 for McAlary, based on median wages for a real estate broker in his area. McAlary contended that compensation should be set at $24,000—the compensation he agreed to when he set up the business. However, the court gave little weight to this argument because the business never paid McAlary the amount. The court reasoned that the compensation was “forgotten, ignored or adopted as mere window dressing,” rather than resulting from an agreement made during an arm’s length negotiation. Because the court found portions of the IRS expert’s valuation of reasonable compensation unpersuasive, the court concluded that McAlary’s reasonable compensation was $83,200 annually. Social security, Medicare, income tax withholding and FUTA taxes of $13,694 were assessed to the corporation.
The IRS also asserted the failure to file and failure to deposit penalties. McAlary attempted to argue the penalties, citing his use of ordinary business care and prudence by engaging and relying on the expert advice of a tax professional in determining compensation. However, the court disagreed and sustained the penalty assessments, stating that McAlary could not provide evidence that his tax professional had the background or expertise to justify reliance on his advice. Although not cited by the court, the fact that the corporation did not actually follow the compensation policy, albeit flawed, likely contributed to the court’s stance that McAlary’s argument was without substance.
These two recent Tax Court cases illustrate IRS concerns about the avoidance of paying reasonable compensation to S corporation officers to avoid FICA and Medicare taxes. The two cases involved companies that paid no wages to officers but reported net income and distributions. With more than 90% of S corporations using a tax professional, clients rely on these experts to guide them in this area. Have you substantively addressed and documented reasonable compensation with your clients? Have you meaningfully determined compensation based on services performed? Would your determination hold up to an IRS valuation of reasonable compensation? Has your client adequately documented loans so that the IRS would not recharacterize the loans as capital contributions and determine the repayments to be wages?
With the IRS focusing more of its resources in the next three years on examinations of S corporations, take a second look at whether your S corporation clients are adequately paying themselves reasonable compensation.
Jim Buttonow, CPA/CITP, is cofounder of Beyond415. He has more than 26 years of experience in IRS practice and procedure. He can be reached at [email protected]. Jennifer Villarino is an attorney and senior researcher atBeyond415. She can be reached at [email protected].
IRS focusing more resources on S corporation examinations
By Jim Buttonow, CPA, CITP and Jennifer Villarino, J.D.elect S corporation
(Article courtesy Taxpro Monthly, National Association of Tax Professionals, October, 2013)
Many business owners elect S corporation status to minimize or status to minimize or avoid social security and Medicare taxes. Minimal or no S corporation wages allow an individual shareholder to avoid self-employment taxes and may allow the corporation to avoid payroll taxes. Many S corporations are companies with one shareholder whose compensation is determined unilaterally and not in an arm’s length negotiation. With 60% of the 4.5 million S corporations owned by a single shareholder, the IRS is concerned about S corporation reasonable compensation.
Two recent S corporation compensation cases remind us of the pitfalls and costs of not paying and reporting reasonable compensation to S corporation officers. They also remind us that S corporation reasonable compensation is an active issue in IRS small business examinations.
These cases both involve a single-shareholder business that failed to pay the officer a reasonable wage. The results of these cases were substantial employment tax liabilities and penalties assessed to the employer.
In Glass Blocks Unlimited v.Commissioner, T.C. Memo 2013- 180 (August 7, 2013), the U.S. Tax Court addressed an S corporation officer, Fredrick Blodgett, who made distributions to himself from the S corporation and did not pay himself any wages. Blodgett, as president and sole shareholder, worked full time for the company, a distributor of glass blocks used in construction, and performed all the work in generating more than $1.5 million in revenue over two years.
In these years, Glass Blocks experienced financial difficulties from the real estate downturn and netted less than $10,000 in total ordinary income. Blodgett did not take any wages from Glass Blocks, nor did he report any income other than the S corporation ordinary income reported on his Form 1040 for the two years in question. During the same time period, the S corporation made distributions to Blodgett of more than $62,000, which Glass Blocks characterized as repayment of loans. With little evidence of loan transactions, the IRS took exception, as it often does in similar situations with closely held corporations. The IRS concluded that the payments from Blodgett were capital contributions and not bona fide loans, and the court agreed. The IRS reclassified more than $62,000 as wages.
The court also agreed with the IRS on the assertion of the failure to file and failure to deposit penalties for the S corporation’s now-delinquent Forms 941 for the periods in question. FICA/Medicare taxes and the resulting penalties amounted to a liability of $13,166 to Glass Blocks.
In Sean McAlary Ltd, Inc. v.Commissioner, T.C. Summary Opinion 2013-62 (August 12, 2013), the U.S. Tax Court heard another S corporation reasonable compensation case. McAlary was entering retirement and decided to supplement his income by becoming a real estate broker. In 2003, he set up an S corporation. In 2004, at the advice of his tax preparer, McAlary set up his annual compensation to be a base of $24,000, plus commissions based on the number of associate brokers with whom he could affiliate his real estate company. Similar to Glass Blocks, McAlary was the sole shareholder of the corporation, its only employee, and the only person in the firm who held a real estate license. McAlary worked long days and performed all of the services essential to managing and operating the business. He contracted with associate brokers to generate sales commissions. In 2006, the S corporation made a net income of $231,454, but did not pay McAlary a salary. However, McAlary did receive transfers totaling $240,000 from the corporation to his personal account. On his Form 1040, McAlary did not report wages from any source, nor did he pay any self-employment tax. McAlary did report his ordinary income from the S corporation.
During the trial, the IRS presented a valuation expert who deemed reasonable compensation to be $100,755 for McAlary, based on median wages for a real estate broker in his area. McAlary contended that compensation should be set at $24,000—the compensation he agreed to when he set up the business. However, the court gave little weight to this argument because the business never paid McAlary the amount. The court reasoned that the compensation was “forgotten, ignored or adopted as mere window dressing,” rather than resulting from an agreement made during an arm’s length negotiation. Because the court found portions of the IRS expert’s valuation of reasonable compensation unpersuasive, the court concluded that McAlary’s reasonable compensation was $83,200 annually. Social security, Medicare, income tax withholding and FUTA taxes of $13,694 were assessed to the corporation.
The IRS also asserted the failure to file and failure to deposit penalties. McAlary attempted to argue the penalties, citing his use of ordinary business care and prudence by engaging and relying on the expert advice of a tax professional in determining compensation. However, the court disagreed and sustained the penalty assessments, stating that McAlary could not provide evidence that his tax professional had the background or expertise to justify reliance on his advice. Although not cited by the court, the fact that the corporation did not actually follow the compensation policy, albeit flawed, likely contributed to the court’s stance that McAlary’s argument was without substance.
These two recent Tax Court cases illustrate IRS concerns about the avoidance of paying reasonable compensation to S corporation officers to avoid FICA and Medicare taxes. The two cases involved companies that paid no wages to officers but reported net income and distributions. With more than 90% of S corporations using a tax professional, clients rely on these experts to guide them in this area. Have you substantively addressed and documented reasonable compensation with your clients? Have you meaningfully determined compensation based on services performed? Would your determination hold up to an IRS valuation of reasonable compensation? Has your client adequately documented loans so that the IRS would not recharacterize the loans as capital contributions and determine the repayments to be wages?
With the IRS focusing more of its resources in the next three years on examinations of S corporations, take a second look at whether your S corporation clients are adequately paying themselves reasonable compensation.
Jim Buttonow, CPA/CITP, is cofounder of Beyond415. He has more than 26 years of experience in IRS practice and procedure. He can be reached at [email protected]. Jennifer Villarino is an attorney and senior researcher atBeyond415. She can be reached at [email protected].