By Paul S. Hamann & Jack Salewski, CPA, CGMA
The modern era for Reasonable Compensation for S Corps started in 2005 with a study of S Corporation Reporting Compliance. This study spawned numerous reports that changed and shaped the way IRS examiners address non-compliance on the issues of Reasonable Compensation. This change can be seen in the differences between Pre-2005 court cases and Post-2005 court cases.
Pre-2005 court cases revolved around S Corp owners who received all their compensation in the form of dividends, and zero (or merely nominal) salary. In the majority of the Pre-2005 cases, the re-classification of distributions as wages was all or nothing.
Post-2005 courts cases revolved around determining whether the Reasonable Compensation figure paid to the S Corp owner was ‘Reasonable’ for the services provided to the S Corp. Three court cases that embody this new era are summarized below.
For the first time, we see the IRS pursuing an S Corp which paid its owner an actual salary. Mr. Watson received $24,000 in salary and approximately $204,000 in dividends. Although there had been an attempt to determine a Reasonable Compensation figure for Mr. Watson, the attempt was too clumsy to pass scrutiny. The IRS showed that even a beginning accountant would make more than $24,000 and a typical accountant of Mr. Watson’s experience would bring in a salary of about $90,000. Mr. Watson took the IRS ruling all the way to the Supreme Court where his final appeal was denied. The Watson case re-affirmed the IRS right to re-characterize some distributions as wages if they believe the Reasonable Compensation figure was not reasonable for the services provided.
A great case to look at and see some of the methods the IRS uses to determine a Reasonable Compensation Figure and how the courts interpret some of their own guidelines to determine a Reasonable Compensation figure. This case gave us the definition of full-time year-round employment as 2,080 hours per year. For the second time we see the topic of various services introduced into the calculation for reasonable compensation as stated in the IRS guidelines, leading to two definitions of Reasonable Compensation:
- Replacement Cost: “McAlary LTD could expect to pay $48.44/hour to another individual in exchange for the services Mr. McAlary performed”
- Fair Market Value: “$100,755 would be FMV of the services Mr. McAlary performed for his S Corp”
Yes, it is possible to lose money and still be required to pay Reasonable Compensation and the Glass Blocks case shows us how. The re-characterization of dividends as wages, in this case, caused Glass Blocks Unlimited to go from small profit to a loss. This case reminds us to treat shareholder loans properly or they may be classified as distributions and be subject to Reasonable Compensation.
The takeaway from all these cases is that the amount of Reasonable Compensation taken must be reasonable for ALL the services the S Corp owner performs for the company and that Reasonable Compensation is triggered by distributions, not profit or loss. Because there is no safe harbor for Reasonable Compensation, the best strategy is to research and document Reasonable Compensation every year. Then, you will have a defensible position if a Reasonable Compensation challenge comes your way.