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Tom Talks Taxes - July 28, 2023
Key court cases on S corporation reasonable compensation
This article is one in a series of articles on reasonable compensation. A previous edition discussed the reasonable compensation issue as applied to S corporations.
Reasonable compensation for an S corporation shareholder/employee is ultimately a facts and circumstances determination. Using so-called “rules of thumb” to determine reasonable compensation amounts is not rooted in the law.
Case law is particularly instructive as it demonstrates how courts view the S corporation reasonable compensation issue and analyze a taxpayer’s situation to determine the reasonable compensation amount.
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In David E. Watson, P.C. v. U.S., 668 F.3d 1008 (8th Cir.), David Watson was an accountant, and his S corporation was a 25% partner in an accounting firm. In tax years 2002 and 2003, Watson took a salary of $24,000 but took distributions of $203,651 and $221,577, respectively.
The IRS initially determined that $130,730.05 and $175,470.00, respectively, of the distributions should be recharacterized as wages; therefore, the IRS assessed $48,519.30 in employment taxes, penalties, and interest against the S corporation for the eight calendar quarters of 2002 and 2003. The IRS valuation expert amended his position several times, concluding that $67,044 of distributions should be recharacterized as wages for each year, giving Watson a $91,044 salary.
The district court agreed with the IRS valuation expert that a reasonable salary for Watson was $91,044. Through reports of accountant compensation, the IRS valuation expert determined that an employee with no investment interest would receive $70,000 in compensation. Since owners billed at 33% higher rates than directors, he adjusted the $70,000 upward by 33%. He then adjusted downward to $91,044 to factor in non-taxable fringe benefits.
The district court’s decision, which the Eighth Circuit upheld, ultimately allowed Watson to take distributions of $136,607 in 2002 and $154,533 in 2003 free of employment taxes. While Watson lost the case, businesses ultimately benefit from the holding as it demonstrates how the S corporation and its shareholder/employee can save significant employment taxes with a proper reasonable compensation analysis.
In Sean McAlary Ltd. Inc. v. Comm., T.C. Summary Opinion 2013-62, Sean McAlary entered the real estate business a few years before the housing crash and quickly became successful. In 2006, he took a distribution of $240,000 from his corporation but did not take any salary, although the corporate minutes showed he could have received a $24,000 salary.
The IRS calculated a reasonable salary for McAlary as $100,755. The IRS valuation expert used the California Occupational Employment Statistics Survey to determine that the median wage for a real estate broker in 2006 was $48.44 per hour. He then multiplied $48.44 by 40 hours per week and 52 weeks per year (although the facts showed that McAlary worked 12-hour days with few days off) to arrive at $100,755.
The Tax Court did not wholly accept the IRS’s calculation, stating that the reasonable compensation analysis is “far from an exact science.” The Tax Court adjusted the hourly rate downward to $40 an hour based on McAlary’s limited experience, modest operations, and a favorable housing market. Multiplying the $40 rate by 40 hours per week and 52 weeks per year, the Tax Court determined McAlary’s reasonable salary to be $83,200, leaving him with $156,800 of distributions free of employment tax.
One more item of note from this case: the IRS valuation expert claimed $100,755 represented 19.5% of the corporation’s gross receipts, which was near industry norms for salary as a percentage of net sales. In a footnote, the Tax Court said
Mr. Ostrovsky did not explain how a comparison of compensation measured as a percentage of gross receipts with compensation measured as a percentage of net sales would aid the Court in this case. In the end, we do not find this portion of Mr. Ostrovsky's report to be persuasive or helpful.
Some tax professionals use an arbitrary percentage of gross receipts instead of a reasonable compensation analysis. Both the Tax Court’s footnote and analysis method indicate this is not an accurate way to determine reasonable compensation.
In Glass Blocks Unlimited v. Comm., T.C. Memo 2013-180, Frederick Blodgett created glass blocks for windows, room dividers, skylights, and other real estate uses. In 2007 and 2008, his S corporation did not pay him a salary, but he took distributions of $30,844 and $31,644, respectively. While the corporation took the position that some of the distributions were repayment of shareholder loans, the Court determined that Blodgett’s payments to the corporations were actually capital contributions and not bona fide loans, so the purported loan repayments to Blodgett were distributions.
The Tax Court upheld the IRS’s determination of Blodgett’s reasonable salary as equal to the total distributions each year, finding that a full-time employee in Blodgett’s line of work would make no less than that amount.
In Goldsmith v. Comm., T.C. Memo. 2017-20, aff'd, 2020 PTC 304 (8th Cir. 2020), Judge Holmes decides several issues related to Scott Goldsmith’s tax troubles, which previously led him to federal prison. The issues were complicated by his law firm’s “chaotic accounting records.”
The opinion succinctly describes the controversy and the Court’s analysis of it:
The Commissioner asserts that because Mr. Goldsmith was an employee of G&A (a fact Mr. Goldsmith conceded during trial) payments made from G&A to him during the years at issue are constructive wages, which would make G&A owe more in payroll tax and Mr. Goldsmith owe more in income tax. Mr. Goldsmith argues that because during those years G&A made no money, it could not have afforded to pay him wages, and any money he took out of G&A was to reimburse him for G&A expenses he himself had paid earlier.
We are very skeptical of the Commissioner's work on this issue. The employee-tax agent assigned to Mr. Goldsmith's case used statistics from the Minnesota Bureau of Labor to find the average salary of attorneys working in the Twin Cities for the years at issue. She then looked at G&A's records and determined that because Mr. Goldsmith was billing time, and G&A was paying him, G&A must have been paying him wages. The first problem here is that the agent did not take into account any loans Mr. Goldsmith made to G&A. We also saw no indication that she considered G&A's operating expenses or whether she even asked herself if she had all the information necessary to make her determination. She admitted that "with [her] experience now, [she] would have taken [expenses and loans] into much more consideration," and that since then she's learned a lot more.
There's no rule that an S corporation has to pay its sole shareholder a wage, especially when it's bleeding money the way G&A did. The real question is one of fact--were the payments a return of capital, repayments of loans, or wages? See Scott Singer Installations, Inc., v. Commissioner , T.C. Memo. 2016-161. We look at all the evidence. See Dixie Dairies Corp. v. Commissioner , 74 T.C. 476, 493 (1980). Mr. Goldsmith bears the burden of proving that funds paid to him by G&A were for repayment of loans… Mr. Goldsmith sought funding for G&A from usurers because reasonable creditors would not finance the firm. Even during the earlier years when he was able to use equity in his home to fund G&A, the business was running at a deficit. From 1997 through 2002 G&A had only one profitable year — 2000, the year of the large contingent fee. Even with that fee, however, G&A was still failing — as shown by the losses in the following years and Mr. Goldsmith's own acknowledgment. For these reasons we find that payments that G&A made to Mr. Goldsmith were not wages, as the Commissioner asserts, and were not reimbursements for expenses as Mr. Goldsmith insists, but rather were a nontaxable return of capital to the extent of his basis.
In conclusion, these cases illustrate the following general principles for determining an S corporation shareholder/employee’s reasonable compensation amount:
It is generally the cost to hire another person to perform the same tasks.
The analysis should use no more than 40 hours per week for 52 weeks per year.
Businesses with consistent losses may not be expected to pay shareholder/employee wages. Nonwage payments to those individuals may escape recharacterization if the shareholder/employee provided loans or capital.
It is not automatically 100% of net income when the shareholder/employee is the only worker in the business.
It is not an arbitrary percentage of corporation gross receipts or net income when the shareholder/employee is the only worker in the business.
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