Warning to S Corp. Shareholders Regarding Reasonable Compensation

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP
Posted: 1/26/2011

S corp. shareholders, please be careful on this issue. Your poor tax CPA is telling you this bad news in an honest attempt to keep you out of trouble.

S Corp. profits earned from the personal services of the S Corp. shareholders need to be treated as “salary” paid to those shareholders, and are subject to Social Security, Medicare and other payroll withholdings and taxes.

Both the IRS and California Franchise Tax Board enforce this rule. Often, S Corp. shareholders take excess cash compensation as a “dividend distribution” from the S Corp. which, by law, are not subject to payroll withholdings and payroll taxes.

Every new S Corp. is warned about this rule in the letter they receive from the IRS on the acceptance of their S corp. election. However, the warning is hard to understand for people unfamiliar with tax jargon.

Here‘s the IRS Website warning on this issue:
http://www.irs.gov/businesses/small/article/0,,id=203100,00.html

Here’s our firm’s Blog regarding a CPA who had his license suspended for not enforcing these rules with his client.
http://community.groco.com/cs/blogs/tax_expert/archive/2010/01/07/32502.aspx

Here’s a January 2011 case where a foolish CPA with his own S Corp. paid himself $24,000 as salary and dividends near $200K. The tax, interest and penalties will be very large. The case will be appealed, but in my view, the IRS clearly will win.
http://online.wsj.com/article_email/SB10001424052748703951704576092371207903438-lMyQjAxMTAxMDIwMTEyNDEyWj.html

Here’s a blog on the IRS audit of John Edwards (Presidential Candidate and other qualities that I won’t mention). He won his tax case. He earned $26 million as a lawyer in a particular year and paid himself “reasonable compensation” of just $300,000 from his S Corp. law firm. $300,000 resulted in the payment of the maximum Social Security tax and a good chunk of Medicare tax, so the IRS conceded the case, because, although Edwards had an economic windfall, on basic tax principles, it is hard to argue that a $300,000 salary is too small to be “reasonable” compared to what lawyers generally earn. That’s the right answer, in my view, so the IRS gave up rather than going to court and losing, and having that rule become case law precedent. It is estimated this legal tax planning saved Edwards $730K in Medicare tax.
http://www.rothcpa.com/archives/000873.php

This issue can be a problem with clients, because it needs to be self-enforced. The S Corp’s. payroll service will not give any warning if S Corp. income is too low. The only warning system is when the CPA realizes too little payroll salary has been reported…which, with new clients, is often long after the year has ended, and it is too late to make year-end payroll adjustments.

We are happy to assist you in evaluating this issue.