Reasonable Compensation in S-Corporations

Watson v. US (DC IA 5/27/2010)


A recent district court case indicates that the courts are siding with the Internal Revenue Service in the area of reasonable compensation.  Mr. David Watson was the president of an accounting firm, Larson, Watson, Bartling and Jeffer.  He owned his portion of LWBJ through a Professional Corporation taxed as an S Corporation (David E. Watson, PC) owned exclusively by Mr. Watson. 


In 2002 and 2003, DEWPC paid Mr. Watson a salary of $24,000 per year, while distributing $118,000 and $221,000 in dividend distributions respectively. 


In February of 2007, the IRS assessed nearly $50,000 in taxes, penalties and interest against DEWPC after it determined that around $305,000 of the dividend distributions should have been wages subject to employment taxes. 


S-Corporations are tax efficient entities where income, losses, deductions, and credits flow through the entity to their respective owners.  Dividend distributions received by the owners are not subject to corporate dividend tax rates (15%) or employment taxes.  Instead, the net taxable income from the company is subject to income tax, regardless of distributions. 


The tax structure of an S-corporation can tempt some owners to avoid paying employment taxes by having officers treat their compensation as cash distributions rather than wages.  The penalty for misclassifying wages is steep - up to 25% for failure to withhold taxes. 


Aaron's Take:  Mr. Watson's salary was unreasonably low, as his $2,000 per month salary was substantially less than his monthly living expenses.  He worked an average of 35 to 45 hours per week for 46 weeks out of the year, bringing his hourly salary to about $10.30 per hour, unreasonably low for any accountant. 


The IRS has issued Fact Sheet 2008-25 listing factors the IRS has considered in determining reasonable compensation, which includes: training and experience, duties and responsibilities, dividend history, timing and method of payment, comparable pay for similar service, and others. 


If you are concerned that your salary may be too low, check www.salary.com and other resources available to your profession.