This scenario is possible because Reasonable Compensation is not tied to Profit or Loss but to Distributions. The IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received by the shareholder. Therefore it does not matter whether or not the company is making or losing money; what matters is whether or not the S Corp owner is taking money (or other items of value) out of the S Corp.
This was the scenario the US Tax Court took up last year in Glass Blocks Unlimited (GBU) V. IRS. GBU was forced to reclassify $30,844 in 2007 and $31,644 in 2008 of distributions as wages. What makes this case so interesting is that GBU had a small profit in 2007 ($877) and 2008 ($8,950) before the IRS Reasonable Compensation challenge.
After the IRS assessed tax penalty and interest, GBU was pushed into the red for 2007 changing GBU net income of $877 to a net loss of -$34,250 according to court documents. Let’s take a look at an example so we can better understand the issue:
- Scott Stone is 100% owner of Stone Concrete, an S Corp.
- In 2015 Scott Stone personally transferred $60,000 to Stone Concrete.
- In 2016 Stone Concrete had a net profit of $877 before considering Scott’s salary.
- Scott elected to take no salary in 2016.
- In 2016 Scott transferred $30,000 (of the original $60,000) back to himself from Stone Concrete.
- Scott’s Reasonable Compensation figure for the services he provided to his S Corp for 2016 was $78,950.
Scott properly classified and treated his $60,000 transfer to Stone Concrete as a loan according to IRS and court guidelines*. Therefore he was able to repay $30,000 of the loan to himself without having to pay Reasonable Compensation first. Stone Concrete’s net profit remained unchanged at $877.
Scott did not properly classify and treat his $60,000 transfer to Stone Concrete as a loan according to IRS and court guidelines*. Therefore the loan was, in fact, additional paid in capital (basis) and the repayment of $30,000 was actually a distribution (return of basis) not a loan repayment. Because Reasonable Compensation needs to be paid before any distributions can be taken, Scott must reclassify his distribution as wages.
When reclassifying the $30,000 of loan repayment as wages Stone Concrete will incur employment taxes of $2,295 for the $30,000 paid to Scott. Stone Concrete will, therefore, be pushed into the red, changing the $877 net profit into a -$31,418 loss.
This example assumes Scott’s CPA caught the issue and treated it properly. If, however, this reclassification was due to an IRS Reasonable Compensation challenge, Stone Concrete’s losses would have been significantly higher after interest and penalties are assessed.
*The Proper Characterization of Transfers as Either Loans or Capital Contributions
Per the Glass Block decision: The S Corp owner bears the burden of proving the transfers were loans. Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. The factors are not equally significant, and no single factor is determinative. Such factors include:
- The names were given to the documents that would be evidence of the purported loans
- The presence or absence of a fixed maturity date
- The likely source of repayment
- The right to enforce payments
- Participation in management as a result of the advances
- Subordination of the purported loans to the loans of the corporation’s creditors
- The intent of the parties
- The capitalization of the corporation
- The ability of the corporation to obtain financing from outside sources
- The thinness of capital structure in relation to debt
- Use to which the funds were put
- The failure of the corporation to repay
- The risk involved in making the transfers