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By Paul S. Hamann & Jack Salewski, CPA, CGMA

In a recent memorandum to its examiners and appeals agents, the IRS lays out steps to keep Reasonable Compensation challenges out of Tax Court.  Great, you say, nobody wants to go to court!

Not so fast. The option of filing a petition in Tax Court provides taxpayers with time and leverage. By following the steps in this memo, IRS examiners can prevent taxpayers who cannot reach a resolution on Reasonable Compensation from filing a petition in Tax Court.  This means:

  1. Tax must be paid now. When filing a petition with the Tax Court, taxpayer can avoid paying the tax until the matter is finally resolved.
  2. Leverage Lost. Filing or even the threat of filing a petition with the Tax Court can give taxpayers and their advocates’ leverage to get the appeals agent to settle the dispute favorably. 

Since 2005, when the IRS began studying the issue of compliance and Reasonable Compensation, the agency has been regularly and consistently improving enforcement and compliance strategies. This relatively unknown memo, prepared by Janine Cook, Deputy Associate Chief Counsel (Exempt Organizations/Employment Tax/Government Entities) to Barbara Wulf, Program Manager (Specialty Exam Policy & Quality, ET policy), is another example of their continued efforts to do just that.

The easiest, best and most cost-effective means for S & C Corps to avoid this kind of snarl is to avoid the challenge in the first place by doing a competent Reasonable Compensation Analysis, using RCReports or some other means. But if one of your clients gets in hot water for not doing so or in spite of doing so, here’s what you need to know.

Examiners and appeals agents are advised to take these two steps to keep the dispute out of tax court:

  1. Confirm the taxpayer agrees that the corporate officer(s) are employees under Section 3121(d)(1). Do not send taxpayer Letter 3523: Notice of Determination of Worker Classification (NDWC).
  2. Confirm the taxpayer does not claim that they are entitled to relief under Section 530 of the Revenue Act of 1978.

The Tax Court has been consistently dismissing cases that meet the above two criteria for lack of jurisdiction because it does not have jurisdiction when the issue at hand is a re-characterization of distributions when the worker classification of the shareholder as an employee is agreed upon.

So what does all this mean in plain English? It means if there is no disagreement regarding the status of the shareholder being an employee, (rather than an independent contractor for example) then there is no need for the examiner or appeals agent to send out Letter 3523.

Does this mean that shareholder employees should consider paying themselves as an independent contractor via 1099? Absolutely not. This has the potential to get your client in even hotter water. The IRS is very clear and has been very consistent regarding the classification of a shareholder who performs services for the corporation as an employee. For an in-depth look at the W-2 verses 1099 question see: 1099 or W-2 for Shareholder-Employees of S Corps?

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