Tax News
A Timely Reminder To Pay Reasonable Compensation
August 19, 2013
Last week, another Tax Court opinion came out slapping down an S corporation shareholder-employee for not taking out reasonable compensation.  As in all of these cases, the taxpayer’s motive in Sean McAlary Ltd, Inc. v. Commissioner, T.C. Summ. Op. 2013-62, is pretty obvious: the S corporation’s income after deducting salary expenses is passed through to the shareholder and taxed as ordinary income.  However, the amount paid out as salary is subject to payroll taxes, in addition to being taxed as ordinary income at the shareholder level.  Where there is only one shareholder, there is nothing but upside to shifting income from that shareholder’s salary earned as an employee to company income/distributions received as a shareholder.

Until the IRS grabs you and imposes penalties, that is.  Some of the facts in McAlary are fairly egregious: the sole shareholder “often worked 12-hour days with few days off” as a real estate agent and broker, personally generated most of the company’s revenue, and contracted with his company to only take a $24,000 salary.  (By contrast, he took out $240,000 as a distribution and reported net pass-through income of $231,454 for the year.)  The only performance bonus built into the contract was based on how many other agents and brokers he was able to recruit, not any other relevant metrics.  This contract looks pretty ridiculous on its face, but then McAlary made it even worse, by not bothering to actually pay out even this modest contractual salary.

The Tax Court was not impressed by McAlary’s arguments that only the contractual $24,000 should be subject to payroll tax as reasonable compensation, although the court did settle on a figure of $83,200, significantly below the IRS-proposed number of $100,755.  (Also keep in mind that even the IRS number is much less than the S corporation’s total income; you can definitely take some shareholder returns even where your services comprise much of the company’s value, you just can’t get too egregiously greedy.)  The court generally embraced the IRS approach of determining an appropriate hourly wage based on industry comparisons and then applying that to a 40-hour workweek, simply choosing a lower hourly wage based on its reading of the facts and circumstances, including “pertinent wage and labor statistics… general market conditions, Mr. McAlary’s somewhat limited experience, and petitioner’s modest operations.”  However, the Tax Court sided entirely with the IRS where it rejected the taxpayer’s reasonable-cause arguments, holding the company liable for penalties under 6651(a)(1) and 6656 due to not filing its forms or remitting withholding deposits on time.

S corporation reasonable compensation is an especially germane topic now because there may be a number of private equity funds, hedge funds, etc. converting to S corporation structures in order to reduce their exposure to net investment income tax.  (See Ivan’s post from January 25 discussing and evaluating this strategy in light of the 1411 proposed regulations.)  These funds’ managers are relying on being able to take out money free of payroll taxes by only taking a limited portion as reasonable compensation.  To the extent the managers’ receipts are subject to pay payroll taxes, the whole point of the restructuring is defeated, so figuring out how little salary can be justified as “reasonable compensation” is essential to the funds’ and managers’ tax planning.

Based on McAlary (and other similar precedents such as JD & Associates, Ltd. and David E. Watson, P.C.), reasonable compensation for shareholder-employees should reflect a substantial analysis.  Industry comparisons are at the heart of it; if the S corporation pays less compensation than similar jobs draw elsewhere, the taxpayer needs to identify factors supporting the differential, such as a smaller company, lower profits, or the shareholder-employee being less qualified than the industry average.  Other, non-industry factors are also relevant, though, such as the profitability of the company and what other employees are paid.  If other, economically less-valuable employees are receiving higher salaries, the taxpayer needs to find a way to justify this treatment separate and apart from paying less than other companies do for the same basic job.  The basic principles are the same as in other types of valuation arguments: find favorable comparisons and then argue for differentiating factors to push the limit.  But don’t just set an implausible arbitrary number, and then neglect to even give it economic effect.
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Tags: "reasonable compensation", McAlary, S-corporation