One of the most significant issues facing S Corporations is whether they pay their shareholder-employee(s) a reasonable compensation. Unfortunately there is no definition of “reasonable compensation” in the Internal Revenue Code or IRS regulations. Thus when reasonable compensation is being discussed in relation to tax preparation or tax planning strategies, tax professionals generally look at court cases for guidance. The recent court cases of Glass Blocks Unlimited (T.C. Memo. 2013-180) and Sean McAlary Ltd. Inc. (T.C. Summ. 2013-62) provide such guidance.
If the IRS is successful in reclassifying distributions and loan payments as wages, not only are there payroll taxes due, but also the interest and penalties associated with the failure to timely remit the payroll taxes.
In Glass Blocks, the court agreed with the IRS that the payments made to the shareholder-employee were properly reclassified as wages rather than as distributions and loan repayments. Although the shareholder had made payments from his personal financial resources to keep the company afloat during the lean years, the IRS found that those payments were capital contributions to equity and not a business loan. The court focused on four factors in ruling in favor of the IRS that there were no loans. First, there was no written agreement or promissory note for the transferred funds; second, no interest was paid; third, the company did not provide security for the loan; and fourth, there was no fixed payment schedule. If a loan is to be treated as a loan, the terms of the transfer must reflect an unconditional obligation for repayment, rather than one that is entirely dependent on the company’s ability to repay. If the company and shareholder do not treat the transfer of funds as a loan, the IRS and the courts will not.
The court also shared some of the factors that the court looked at to determine a reasonable salary. These included the shareholder-employee’s role in the business operations, comparison of salaries to what other similar businesses pay, the nature and condition of the company, and potential conflicts of interest.
In McAlary, the court stated it had an arm’s-length issue with the written employment agreement between the company and the shareholder-employee. There was only one shareholder-employee who served as the sole director for the company, thus he represented both himself and the company when executing the employment agreement. In addition, the parties did not adhere to the terms of the employment agreement. This case also discussed the IRS’s use of metric tools, statistics and surveys in determining reasonable compensation. In computing its reasonable salary, the IRS used comparable salaries published by independent third parties.
What are the lessons learned from these court cases? First, shareholder-employees often ignore the advice of their tax professionals or fail to work with a tax professional in determining a reasonable salary. Second, reasonable compensation must be determined by looking at third party publications to support the salary being paid to the shareholder-employee as being fair and reasonable for the services provided. Third, all agreements executed between the company and its shareholders need to be written as it the agreements were between independent third parties and the terms of such agreements must be followed.
Note: Because each S Corporations tax situation is different, if you want to learn more about the IRS’s rules regarding reasonable compensation, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation.
You can also schedule a consultation at Click Here. To learn more about various tax and business services, visit Tax Preparation Services and Small Business Accounting Services
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