By Paul S. Hamann & Jack Salewski, CPA, CGMA
The IRS usually wins when it challenges an S Corp.’s Reasonable Compensation in court. Over the years there have been in the neighborhood of 25 to 30 such cases. The IRS has come out on top in all except one: The Davis Case. What made Davis different? What valuable takeaways are there for you and your clients?
The case focused on two concepts that every S Corp. and business advisor should understand:
- Officer in name only
- Substantial services
Background: Mile High Calcium was owned by Carol L. Davis and her husband Henry Adams. This case revolved around transfers in and out of Mile High Calcium from 1987 to 1989. The IRS re-characterized all transfers for the timeframe in question to Reasonable Compensation, resulting in assessed taxes, interest and penalties of $39,220. Carol L. Davis successfully sued the IRS for a partial refund based on the following two-pronged defense focusing on each of the two owners:
Henry Adams: Henry was officially listed as the President of Mile High Calcium. It has been the author’s experience, and we see it demonstrated here in the Davis case, that the IRS will, by default, assume anyone listed as an officer of an S Corp. to be performing services, and therefore an employee who should be paid Reasonable Compensation.
The IRS’s problem here was that Henry didn’t actually provide any services (had NO active participation in the business), and Carol had the documents to prove it:
- Henry worked for outside employers during this timeframe, and Carol produced W-2s to back this up.
Therefore, Henry was what is referred to as an “Officer in name only” and there is an exception for officers who perform only minor services in the treasury regulations: Treas. Reg. § 31.3121(d)-(1)(b)
Carol won this portion and half of the recharacterization was wiped off the books. Carol then defended herself.
Carol L Davis: Carol was in fact an employee of Mile High Calcium. However, the IRS’s problem was that her services had minimal value, and she could prove it:
- Carol only worked 12 hours per month: approximately 2.75 hours per week
- Comparability data showed the work Carol performed to be valued at $8.00 per hour
When a new calculation was performed based on the time Carol actually dedicated to the business and the value of that time, the original assessment of $39,222 was reduced to $647.
The Davis case is frequently pointed to as the one the IRS lost. However, I would argue that the IRS did not lose this case as much as they did not win it. Why? Because the IRS was still successful in forcing the taxpayer to pay Reasonable Compensation for the services actually provided to their company. Carol’s ability to prove the services were minimal won out over the IRS’s simplistic assumption that recharacterized all distributions as Reasonable Compensation. The IRS ‘all or nothing’ strategy, which was employed through 2005, failed when countered with real evidence. For more about what changed in 2005 please see: Three Court Cases that Define the Modern Era of Reasonable Compensation
- If an officer of an S Corp. is not performing any services and is therefore an Officer in name only, take the following steps to protect your client:
- Document the fact that the shareholder is an Officer in name only and memorialize it in the corporate minutes.
- File form 1125-E and enter 0% in column (c) Percent of time devoted to business
- Assuming the Officer-in-Name-Only’s time is otherwise occupied, ask the Officer to keep records, such as W-2s.
- Ensure that shareholders performing services are being paid Reasonable Compensation, even if those services seem minor - as they were for Carol L Davis - because avoiding a challenge costs less than winning one:
- The IRS requires any shareholder who performs substantial services to be paid Reasonable Compensation
- A smart way to think about what qualifies as substantial services would be to analyze the services provided to determine:
- Are they a necessary component of running the business?
- If so, pay the shareholder-employee for those services, no matter how small the payment.