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"Reasonable Compensation" Required for Actively Involved S Corp Owners

As one small business owner learned, failure to take a salary and pay employment taxes can be a costly decision

Ron Adams

Ron Adams

An attractive feature of an S corporation (or an LLC or partnership that is taxed as an S corp) is that its net earnings are not subject to self-employment tax. An S corporation does not separately pay tax; rather, its income or loss flows through to the shareholders and is reported on a Schedule K-1 to be included in the shareholder's Form 1040.

That advantage that gives rise to possible tax abuse. S corp owners who are active in their companies must receive "reasonable compensation" in the form of a salary, and the IRS is increasingly alert to owners who perform employee-like functions in an S corp but do not pay FICA and other payroll taxes.

Tax Court Case

A recent court case illustrates the perils to active, non-salaried owners. Frederick Blodgett was the sole shareholder and full-time president of an S corp, Glass Blocks Unlimited, that supplied home builders. The company had no employees. When the Great Recession hit, business declined and, on multiple occasions, Blodgett transferred to the company his personal funds to cover operating expenses.

Blodgett took no salary during that time, but in 2007 he took a distribution from the company of about $31,000. He did the same in 2008. He also received roughly $37,000 in loan repayments from the company. Blodgett did not have any other employment during 2007 or 2008, and the only income he reported on his Form 1040 was the pass-through income from Glass Block and a small amount of interest income.

In an employment tax audit, the IRS determined that Blodgett should be classified as an employee of Glass Block and that the distributions in 2007 and 2008 constituted wages for which FICA taxes should have been paid. Blodgett challenged the assessment, and the dispute ended up in tax court.

In court, Blodgett's claim was undermined by his failure to pay himself a salary even though he was Glass Block's only officer, operated the company essentially by himself, and generated all of its income. In the end, the court allowed the IRS's computation of the employment tax, as well as penalties for failure to deposit taxes and failure to file employment tax returns.

Lessons

This isn't the only case involving insufficient salaries from S corporations. What makes this one interesting is that the court allowed the full amount of the distributions to be classified as salaries, despite the fact that the business was only nominally profitable at the time.

Clearly, reporting no salary on the line for officers' compensation on Form 1120S is asking for trouble. But how much of a salary should you take? That's not an easy question. A professional with an advanced degree who takes a salary of $30,000 a year for the full-time management of an S corporation generating $500,000 in net income would be suspect. But taking a salary of $175,000 a year for a 40-hour week might not be. In arriving at a reasonable salary, the IRS and the courts could look at a number of factors, including the nature of the work performed, the success of the business, past salary, comparisons of the employee's salary to those paid by similar companies for similar services, the character and condition of the company, time spent, potential conflicts of interest, presence of a contract or formula for determining salary, loan restrictions, etc.

If the business requires additional capital (for example, because it's expanding) and the profits are plowed back into the business, you may be able to justify a smaller salary. Taking distributions suggests the business doesn't need the cash, and it's a way to compensate the officer/shareholder other than through salary. On the other hand, in a business with a large capital investment, an officer/shareholder might be able to justify the distributions as a return on investment. That's particularly true if prior disbursements have been small because of cash flow problems.

If you are unsure whether the amount of salary you are taking (or plan to take) is likely to satisfy the "reasonable compensation" requirement, a consultation with your accountant or tax attorney would be a prudent move.