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Court sets 'reasonable' comp for Iowa CPA S corporation shareholder

December 30, 2010

The IRS last week won a battle in the war against S corporation owners who pay less salary -- and less FICA and Medicare tax -- than the government would wish. A U.S. District Court in Des Moines ruled against a Des Moines-area CPA who took only $24,000 annual salary of his approximately $200,000 in earnings for 2002 and 2003 from his CPA business. The court reclassed $67,044 of his S corporation distributions as salary for each year, giving him FICA/Medicare wages of $91,044.

The IRS hates the use of S corporations to minimize FICA taxes -- the so-called "John Edwards Shelter." S corporations are not taxed on their own income; instead the income is taxed directly on the tax returns of their owners via a K-1 information return. Unlike partnership income, S corporation K-1 earnings are not subject to the 12.4% combined employer-employee FICA tax and the 2.9% Medicare tax, S corporation shareholders try to get away with as low a salary as possible. That's why every IRS letter accepting an S election includes a stern warning to take an appropriate salary.

This case involved a CPA firm that was apparently set up as a partnership of S corporations, with a separate S corporation for each partner. Each S corporation would pay salary to its shareholder. The judge decided that $24,000 just wasn't enough (emphasis added):

A reasonable person in [the Taxpayer’s] role within [The CPA firm partnership] would unquestionably be expected to earn far more than a $24,000 salary for his services. As such, the $24,000 salary [the Taxpayer] opted to pay himself as [the S corporation’s] sole shareholder, officer, and employee, is incongruent with the financial position of [The CPA firm partnership] and in light of [the Taxpayer’s] experience and contributions to [The CPA firm partnership], and when compared to the approximately $200,000 in distributions [The S corporation] received in each of 2002 and 2003. Moreover, the $24,000 salary is low when compared to salaries that could reasonably be expected to be earned by persons with experience similar to that of [the Taxpayer], and holding a position such as [the Taxpayer] held in a firm comparable to [The CPA firm partnership]. Indeed, upon evaluation of all of the facts and circumstances in this case, the Court is convinced that [The S corporation] structured [the Taxpayer’s] salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that dividends paid to [the Taxpayer] were actually "remuneration for services performed."

So what does this mean for S corporation shareholders who don't want to pay more employment taxes than necessary, but who don't want trouble with the IRS? The decision is very fact-specific, with expert testimony on appropriate salary levels, so conclusions are tricky.

A good place to start is with the compensation of your best-paid non-shareholders. If a shareholder has comparable or heavier responsibilities than the best-paid non-shareholder, it seems unwise to pay the shareholder less than the non-shareholder. In this case the shareholder was paid less than a newly-minted accountant coming out of school.

Cite: David E. Watson, P.C., USDC IA-SC, #4:08-cv-442 (12/23/2010).

Related:

HOW NOT TO DETERMINE YOUR S CORPORATION COMPENSATION

Reputation and skill (covering failed 2010 proposed legislation to force some S corporation K-1 income to be subject to self-employment tax).


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