By Paul S. Hamann & Jack Salewski, CPA, CGMA
We regularly emphasize how important it is to have your S Corp clients who perform services for their S Corp research and document their Reasonable Compensation as a strategy for warding off an IRS Reasonable Compensation challenge.
But what about protecting the shareholders who don’t perform services, especially if they’re listed as an officer of the corporation.
For a small S Corp, holding shareholder meetings and keeping minutes can seem a meaningless chore, especially when just one spouse runs the business. Why hold a “meeting” with my husband, a wife may wonder. We live together! He has his own full-time job and knows nothing of my business. What’s the point? Ironically, it is just this type of scenario that makes shareholder meeting and minutes essential.
A 30 year veteran of the IRS who worked as an examiner, a supervisor and appeals agent had this to say about corporate minutes.
“One of the first things the examiner should do in an audit is ask to see the corporate minute book. If the examiner sees that a taxpayer took the time to best determine what shareholders should be paid, the examiner would most likely indicate this on their lead sheet of audit issues and not continue to pursue the issue. IRS agents hate to start a corporate audit and see that the taxpayer kept no corporate minutes. This is a poor corporate practice that should be corrected by any responsible tax preparer.” Dennis Tafelski Internal Revenue Agent – Retired
Keeping this in mind, advising your clients to hold regular shareholder meetings is a simple step and provides relied upon documentation and an added layer of defensibility with the IRS. Because the overwhelming majority of S Corp’s have three or fewer shareholders, quickly documenting all of the shareholders Reasonable Compensation or lack of it is a simple task that takes just a few minutes.*
It’s very common for officers to not perform any services, especially among S Corp’s owned by a husband-and-wife team. In the early days, when the corporation is formed, the stock is split 50-50 between husband and the wife and then comes electing officers. Everyone’s excited about the new business and wants to take on a role, even if that role is symbolic.
However, that symbolic officer role can cause complications. It has been our experience that if the S Corp is examined, the IRS auditor will look for Reasonable Compensation payments to all officers. When they don’t see any for the officer who was not performing services, they will re-characterize the distributions that were paid out as reasonable compensation and assess penalties and interest.
This very scenario came up in a court case: Davis v. IRS.
According to court documents, Mile High Calcium was owned by a husband-and-wife team – Carol Davis and her husband Henry Adams. Carol worked part time for Mile High Calcium and her husband Henry Adams was listed as president but did not perform any services.
When the IRS audited Mile High Calcium, they re-characterized the distributions paid to Henry Adams as compensation because he was listed as the company’s President. Davis was able to prove Henry Adams did not perform any services for Mile High Calcium and was therefore in officer in name only.
There is an exception for officers who perform only minor services:
“If an officer does not perform any services or only performs minor services and is not entitled to compensation, the officer would not be considered an employee.” Treas. Reg. § 31.3121(d)-(1)(b)
The court agreed with Davis and struck down the IRS re-characterization of distributions as wages for Henry Adams. However, because Carol Davis did work part-time for Mile High Calcium, she was required to pay Reasonable Compensation for the services she provided. So while the S Corp won part of their case, it cost dearly.
Takeaway: Encourage your S Corp clients to use corporate minutes to their advantage. If a shareholder performs services for the S Corp, research and document the Reasonable Compensation figure and adopt it into the corporate minutes. If the shareholder does not perform services for the S Corp document this is as well. A few minutes on this could save your clients a tremendous amount of time and money in the future.
*Any questions on corporate minutes should be referred to the businesses legal counsel.